Aps 116 Market Risk Final Jan2012

January 2012
Prudential Standard APS 116

Capital Adequacy: Market Risk
Objective and key requirements of this Prudential
Standard
This Prudential Standard aims to ensure that an authorised deposit-taking institution

engaging in activities that give rise to risks associated with potential movements in
market prices adopts risk management practices and meets regulatory capital that are
commensurate with the risks involved.
The key requirements of this Prudential Standard are that an authorised deposit-taking
institution must:
have a framework to manage, measure and monitor market risk commensurate

with the nature, scale and complexity of the institutions operations; and
use the standard method or an APRA-approved internal model approach to

determine the institutions capital requirement for market risk.
APS 116 - 1
January 2012
Table of contents
Prudential Standard
Authority ...................................................................................................... 3
Application ................................................................................................... 3
Scope .......................................................................................................... 3
Definitions .................................................................................................... 4
Key principles .............................................................................................. 5
The TFC capital requirement ....................................................................... 5
The standard method................................................................................... 6
The internal model approach ....................................................................... 6
Combination of the internal model approach and the standard method....... 7
Attachment A ............................................................................................. 8
Governance and the trading book policy statement and prudent
valuation practices .................................................................................... 8
Board and senior management responsibilities ........................................... 8
The trading book .......................................................................................... 8
Measuring currency exposure ................................................................... 11
Attachment B ........................................................................................... 13
The standard method .............................................................................. 13
Interest rate risk ......................................................................................... 14
Equity position risk ..................................................................................... 28
Foreign exchange risk ............................................................................... 31
Commodities risk ....................................................................................... 32
Treatment of options .................................................................................. 34
Attachment C ........................................................................................... 39
The internal model approach .................................................................. 39
Key requirements....................................................................................... 39
General criteria .......................................................................................... 41
Qualitative standards ................................................................................. 41
Specification of market risk factors ............................................................ 43
Quantitative standards ............................................................................... 44
Stress testing ............................................................................................. 45
Model review.............................................................................................. 46
Treatment of specific risk ........................................................................... 47
Framework for the use of back-testing....................................................... 54
Attachment D ........................................................................................... 56
Treatment of credit derivatives in the trading book ............................. 56
Application ................................................................................................. 56
General principles - General market risk ................................................... 57
General principles - Specific risk................................................................ 57
Credit-default swaps .................................................................................. 57
Total-rate-of-return swaps ......................................................................... 57
Cash-funded credit-linked notes ................................................................ 58
Nth-to-default basket credit derivatives ....................................................... 58
Specific risk offsetting ................................................................................ 59
APS 116 - 2
January 2012
Authority
1. This Prudential Standard is made under section 11AF of the Banking Act 1959
(Banking Act).
Application
2. This Prudential Standard applies to all authorised deposit-taking institutions

(ADIs), with the exception of:
(a) foreign ADIs within the meaning of subsection 5(1) of the Banking Act;
and
(b) ADIs that:
(i) do not conduct trading book activity and do not have any foreign
exchange or commodity positions; and
(ii) have included a statement to this effect in their description of their

risk management systems; and that statement also outlines the
arrangements in place to ensure that trading book activity does not
take place.
3. A reference to an ADI in this Prudential Standard shall be taken as a reference

to:
(a) an ADI on a Level 1 basis; and
(b) a group of which an ADI is a member on a Level 2 basis.
Level 1 and Level 2 have the meaning in Prudential Standard APS 110 Capital
Adequacy (APS 110).
Where an ADI to which this Prudential Standard applies is a subsidiary of an

authorised non-operating holding company (authorised NOHC), the authorised
NOHC must ensure that the requirements in this Prudential Standard are met on
a Level 2 basis, where applicable.
Scope
4. This Prudential Standard applies to all:
(a) trading book positions; and
(b) banking and trading book positions that give rise to foreign exchange or
commodity risks.
For the purposes of this Prudential Standard, no distinction is drawn, in

principle, between risks arising from physical positions and from positions in
derivative instruments.
APS 116 - 3
January 2012
5. The treatment of counterparty credit risk capital requirements is excluded from

this Prudential Standard and must be determined in accordance with Prudential
Standards APS 112 Capital Adequacy: Standardised Approach to Credit Risk
(APS 112) or APS 113 Capital Adequacy: Internal Ratings-based Approach to
Credit Risk (APS 113), as appropriate.
Definitions
6. The following definitions are used in this Prudential Standard:
(a) credit-event payment - the amount that is payable by the credit

protection provider to the credit protection buyer under the terms of the
credit derivative contract following the occurrence of a credit event. The
payment can be in the form of physical settlement (payment of par in
exchange for physical delivery of a deliverable obligation of the reference
entity) or cash settlement (either a payment determined on a par-less-
recovery basis, i.e. determined using the par value of the reference
obligation less that obligations recovery value, or a fixed amount, or a
fixed percentage of the par amount);
(b) credit events - events affecting the reference entity that trigger a
credit-event payment under the terms of the credit derivative contract;
(c) deliverable obligation - any obligation of the reference entity that can be
delivered, under the terms of the contract, if a credit event occurs. A
deliverable obligation is relevant for credit derivatives that are to be
physically settled;
(d) general market risk - the risk of loss owing to changes in the general
level of market prices or interest rates. It arises from positions in interest
rate, equities, foreign exchange and commodities;
(e) market risk - comprises general market risk and specific risk;
(f) marking-to-model - any valuation that has to be benchmarked,

extrapolated or otherwise calculated from a market input;
(g) model approval - the written approval from APRA to an ADI to adopt an
internal model approach to market risk;
(h) nth-to-default credit derivative - a contract where the payoff is based on

the nth asset to default in a basket of underlying reference instruments.
Once the nth default occurs the transaction terminates and is settled;
(i) reference entity - the entity or entities whose obligations are used to
determine whether a credit event has occurred under the terms of the
credit derivative contract;
(j) reference obligation - the obligation used to calculate the amount payable
when a credit event occurs under the terms of a credit derivative contract.
APS 116 - 4
January 2012
A reference obligation is relevant for obligations that are to be cash settled

(on a par-less-recovery basis);1 and
(k) specific risk - the risk that the value of a security will change due to
issuer-specific factors. It applies to interest rate and equity positions
related to a specific issuer;
(l) traded market risk, foreign exchange and commodities capital

requirement (TFC capital requirement) - the regulatory capital that an
ADI is required to hold against its exposure to market risk in accordance
with this Prudential Standard; and
(m) underlying exposure - the exposure that is being protected by the credit
derivative.
Key principles
7. An ADI that wishes to operate a trading book must, in accordance with

Attachment A, submit for APRAs approval a trading book policy statement that
specifies those activities that belong in the trading book.
8. An ADI must allocate positions in financial instruments to its trading book if

they are held with trading intent or in order to hedge other elements of the
trading book. In allocating positions, an ADI must be guided by its trading book
policy statement.
9. An ADI must maintain a framework for prudent valuation practices for trading
book positions.
10. An ADI operating in the foreign exchange, commodities, interest rate or equities
markets must ensure that appropriately robust risk measurement and
management systems are in place.
11. An ADI must hold capital against:
(a) market risks arising from positions allocated to the trading book; and
(b) all foreign exchange and commodity risks.
The TFC capital requirement
12. An ADI must calculate the TFC capital requirement using one of the following
methods:
(a) the standard method described in Attachment B, under which the TFC
capital requirement is the sum of the market risk charges calculated in
accordance with that method;
1
A reference obligation will typically also be a deliverable obligation unless otherwise excluded.
APS 116 - 5
January 2012
(b) the internal model approach described in Attachment C, under which the
TFC capital requirement is the measure of market risk derived from
applying that approach; or
(c) a combination of the standard method and the internal model approach, in
which case the TFC capital requirement is the sum of the market risk
capital requirements determined under the two methodologies.
13. Unless required to do otherwise by APRA (and subject to the conditions in

paragraph 2 of Attachment B and paragraph 6 of Attachment C being satisfied):
(a) an ADI that has market-related activities in Australia and offshore

branches (offshore Level 1 sites) and manages those market-related
activities centrally may calculate its Level 1 TFC capital requirement
allowing for netting and offsetting of short and long positions in exactly
the same instrument that have been taken within the ADI, whether in
Australia or an offshore Level 1 site; and
(b) an ADI that has market-related activities in Australia and either offshore
branches or offshore subsidiaries (offshore Level 2 sites), and manages
those market-related activities centrally may calculate its Level 2 TFC
capital requirement allowing for netting and offsetting of short and long
positions in exactly the same instrument that have been taken within the
group, comprising the entities in Australia and the offshore Level 2 sites.
In each case the ADI may do so regardless of where the positions are booked
(refer to paragraph 2 of Attachment B) and, if using the internal model
approach, allowing for risk diversification between positions (refer to paragraph
6 of Attachment C).
The standard method
14. An ADI that does not have model approval must calculate its TFC capital
requirement using the standard method as set out in Attachment B and, in
relation to credit derivative instruments held in the trading book, Attachment
D.2
The internal model approach
15. An ADI may apply for written approval from APRA to use an internal model
for capital adequacy purposes.
16. APRA may, in writing, approve the use of an internal model by an ADI. The
model approval may specify how the internal model is to apply in relation to the
ADI, including approvals under paragraphs in Attachment C. APRAs prior
written approval is required for any material changes to the market risk internal
model. Prior notification to APRA is required for material changes to other
2
Attachment D also contains certain requirements for ADIs transacting in credit derivatives
irrespective of the method they use for calculating its traded market risk, foreign exchange and
commodities capital requirement capital requirement.
APS 116 - 6
January 2012
components of the market risk management framework. APRA may impose

conditions on the model approval.
17. Once an ADI has obtained model approval, it must continue to employ that
internal model on an ongoing basis unless, or except to the extent that, the
model approval is revoked or suspended in respect to some or all of the ADIs
market risk exposures. A return, at the ADIs request, to the standard method to
market risk will generally only be permitted in exceptional circumstances.
18. APRA may, at any time in writing to the ADI, vary or revoke a model approval,
or impose additional conditions on the model approval if it determines that:
(a) the ADI does not comply with this Prudential Standard; or
(b) it is appropriate, having regard to the particular circumstances of the ADI,

to impose the additional conditions or make the variation or revocation.
19. Where an ADIs model approval has been varied or revoked, APRA may, in
writing, require the ADI to revert to the standard method to measure market risk
for some or all of its market risk exposures, until it meets the conditions
specified by APRA for returning to the internal model approach.
20. An ADI that has received model approval from APRA may rely on its own
internal estimate (based on the approved market risk measurement model) of
market risk for determining its TFC capital requirement. That estimate must be
fundamentally sound and consistent with the scope of market risk defined in
paragraph 6(e) of this Prudential Standard.
21. APRA may, in writing, require an ADI to reduce its market risk or increase its
capital if APRA considers that the ADIs capital for market risk is not
commensurate with the ADIs market risk profile.
Combination of the internal model approach and the standard method
22. An ADI may, subject to APRAs written approval, use a combination of the
internal model approach and the standard method. In doing so, the ADI must
comply with the requirements detailed in Attachment C.
23. An ADI must not use a combination of the two methodologies within a
particular risk category (e.g. interest rates, foreign exchange, equities and
commodities) and within the same regional centre without prior written
approval from APRA.
24. APRA may require an ADI that has model approval that does not cover all risk
categories to extend the internal model to cover other market risk categories.
APS 116 - 7
January 2012
Attachment A
Governance and the trading book policy statement

and prudent valuation practices
Board and senior management responsibilities
1. An ADIs Board of directors (Board) is responsible for approving strategies and

policies with respect to market risk and ensuring that senior management takes
the steps necessary to monitor and control these risks.
2. In particular, the Board, or a Board committee, must ensure that the ADI has in
place adequate systems to identify, measure and manage market risk, including
identifying responsibilities, providing adequate separation of duties and
avoiding conflicts of interest. An ADI must inform APRA of all significant
changes in these systems and in its market risk profile and must ensure that
market risk capital requirements are met on a continuous basis and that intra-day
exposures are not excessive.
The trading book
3. An ADI must allocate to the trading book positions in financial instruments,

including derivative products and other off-balance sheet instruments, that are
held either with trading intent or to hedge other elements of the trading book.
Positions held with trading intent are those which:
(a) are held for short-term resale; or
(b) are taken on by the ADI with the intention of benefiting in the short-term
from actual and/or expected differences between their buying and selling
prices, or from other price or interest rate variations; or
(c) arise from broking and market-making.
4. For a position to be eligible to receive trading book capital treatment, an ADI

must have:
(a) a clearly documented trading strategy for the position/instrument or

portfolios that has been approved by senior management (which must
include the expected holding horizon); and
(b) clearly defined policies and procedures for the active management of
positions such that:
(i) positions are managed on a trading desk;
(ii) position limits are set and monitored for appropriateness;
(iii) dealers have the autonomy to enter into and manage positions within
agreed limits and according to the agreed strategy;
APS 116 Attachment A - 8

January 2012
(iv) positions are marked-to-market daily and when marking-to-model

the parameters are assessed on a daily basis;
(v) positions are reported to senior management as an integral part of

the institutions risk management process; and
(vi) positions are actively monitored with reference to market

information sources and assessments are made of the market
liquidity or the ability to hedge positions or the portfolio risk profile;
this includes assessments of the quality and availability of market
inputs to the valuation process, level of market turnover and sizes of
positions traded in the market.
5. To obtain an accurate and fair measure of market risk, an ADI may, subject to
prior written approval from APRA, include within its market risk measure
certain non-trading instruments which hedge trading activities. Such instruments
will be subject to the credit risk capital requirements (refer to APS 112 or APS
113 as appropriate) but not to specific risk capital charges.
6. An ADI that raises funds by the issue of instruments may only include these
positions in the trading book if the instrument meets the trading book definition.
7. A banking book exposure hedged using a credit derivative booked in the trading
book cannot be treated as hedged for regulatory capital purposes unless an ADI
purchases a credit derivative that meets the requirements for recognition for
credit risk mitigation purposes from an eligible third-party credit protection
seller (refer to Attachment H to APS 112 or Attachment B of APS 113 as
appropriate). Where third-party protection is recognised as hedging a banking
book exposure for regulatory capital purposes, neither the internal nor external
credit derivative hedge can be included in the trading book for regulatory capital
purposes.
8. An ADI may only include term trading-related repo-style transactions that it

accounts for in its banking book as part of its trading book for regulatory capital
purposes if all such repo-style transactions are included. For this purpose,
trading-related repo-style transactions are limited to those that meet the
requirements of paragraphs 3 and 4 in this Attachment and both legs are in the
form of either cash or securities that can be included in the trading book. All
repo-style transactions are subject to a banking book counterparty credit risk
charge regardless of where they are booked.
9. For transactions dealt internally within an ADI, the ADI:
(a) must either:
(i) eliminate all internal transactions between portfolios within the

trading book before measuring positions exposed to market risk; or
(ii) include any or all internal deals in their position measurement

provided this is done on a consistent basis; and

January 2012
(b) must include internal transactions dealt between the trading book and the
banking book in the measurement of trading book positions.
10. An ADI must ensure that a clear audit trail is created at the time transactions are
entered into, to facilitate monitoring of compliance with the criteria by which
items are allocated to the trading or banking book.
The trading book policy statement
11. An ADIs trading book policy statement must detail:
(a) whether the ADI intends to operate a trading book and whether it has
relevant positions in interest rates, equities, foreign exchange or
commodities;
(b) who can approve or modify the trading book policy statement;
(c) the activities the ADI considers to be trading and as constituting part of
the trading book for the purposes of calculating capital;
(d) the valuation methodology to be adopted for trading book exposures,

including:
(i) the extent to which an exposure can be marked-to-market daily by

reference to an active, liquid two-way market;
(ii) for exposures that are marked-to-model, the extent to which the ADI
can:
(A) identify the material risks of the exposure;
(B) hedge the material risks of the exposure with instruments for
which there is an active, liquid two-way market; and
(C) derive reliable estimates for the key assumptions and

parameters used in the model; and
(iii) the extent to which the ADI can and is required to generate
valuations for the exposure that can be validated externally in a
consistent manner;
(e) whether there are any structural foreign exchange positions. Where
appropriate, the operational definition of positions to be excluded from the
calculation of an ADIs foreign exchange exposure must be outlined (refer
to paragraphs 14 to 17 of this Attachment). A description of the policies
covering the identification and management of structural foreign exchange
positions, to ensure that trading activities are not classified as structural,
must also be included;
(f) when and how the statement will be subject to regular review;

January 2012
(g) the extent to which legal restrictions or other operational requirements

would impede the ADIs ability to effect an immediate liquidation or
hedge of an exposure in the trading book; and
(h) the extent to which the ADI is required to, and can, actively risk manage
an exposure within its trading operations.
12. An ADI must immediately notify APRA of any material changes to its trading
book policy statement.
13. The trading book policy statement must be incorporated into an ADIs
description of its risk management systems and be covered by the annual
management review.
Measuring currency exposure
14. For the purpose of calculating its TFC capital requirement, an ADI must include
in its measurement of exposure to each currency the following:
(a) the net spot position, i.e. all asset items less all liability items, including
accrued interest and other accrued income and accrued expenses,
denominated in the currency in question;
(b) the net forward position, i.e. all amounts to be received less all amounts to
be paid under forward foreign exchange transactions, including currency
futures, the principal on currency swaps not included in the spot position,
and interest rate transactions such as futures and swaps denominated in a
foreign currency;
(c) guarantees (and similar instruments) that are certain to be called and likely
to be irrecoverable; and
(d) any other item representing a profit or loss in foreign currencies.
15. An ADI may also include in its measurement of currency exposure unearned but
expected future interest and anticipated expenses if the amounts are certain and
the ADI has hedged them. If an ADI includes future income/expenses, it must
not select only expected future flows which reduce its position but must treat all
on a consistent basis.
16. If an ADI has deliberately taken a position to either partially or totally hedge
against the adverse effect of the exchange rate on its capital ratio, it may
exclude the position from the measurement of exposure if:
(a) the position is of a structural (refer to paragraph 17 of this Attachment)

or non-trading, nature;
(b) the structural position does no more than protect the ADIs capital
adequacy ratio;
(c) the position cannot be manipulated for speculative or profit-driven

purposes; and

January 2012
(d) any exclusion of the position is applied consistently, with the treatment of
the hedge remaining the same for the life of the assets or other items.
17. A structural position includes:
(a) any position arising from an instrument which qualifies as capital of the
ADI under Prudential Standard APS 111 Capital Adequacy:
Measurement of Capital (APS 111); or
(b) any position entered into in relation to the net investment in a

self-sustaining subsidiary, the accounting consequence of which is to
reduce or eliminate what would otherwise be a movement in the foreign
currency translation reserve; or
(c) investments in overseas subsidiaries or associates that are fully deducted

from an institutions capital for capital adequacy purposes under APS 111.

January 2012
Attachment B
The standard method
1. The standard method comprises a range of alternative methodologies an ADI

may use to calculate the market risks arising from its trading activities. The
capital requirement under the standard method is the sum of the capital charges
calculated in accordance with this Attachment and, for credit derivatives,
Attachment D.
2. Unless required to do otherwise by APRA:
(a) an ADI that has market-related activities in Australia and offshore

activities centrally may, for the purposes of calculating its Level 1 TFC
capital requirement, report short and long positions in exactly the same
instrument within any of those sites on a net basis, regardless of where
they are booked; and
(b) an ADI that has market-related activities in Australia and offshore Level 2
sites (offshore branches or offshore subsidiaries) and manages those
market-related activities centrally may, for the purposes of calculating its
Level 2 TFC capital requirement, report short and long positions in
exactly the same instrument within any of those sites on a net basis,
regardless of where they are booked;
subject to the following conditions:
(c) positions taken in an offshore site may only be netted or offset against
positions taken in Australia or in other offshore sites if the position-taking
of that offshore site is monitored by the ADIs Australian office on a daily
basis;
(d) positions taken in an offshore site must not be netted or offset against
positions taken in Australia or in other offshore sites where there are
obstacles to the quick repatriation of profits from that offshore site or from
offshore transactions taken by the ADI itself; and
(e) positions taken in an offshore site must not be netted or offset against
positions taken in Australia or in other offshore sites where there are legal
and procedural difficulties in carrying out the timely management of risks
on a consolidated basis.
Where the conditions (c) to (e) do not allow for positions in an offshore site to
be netted or offset, an ADI must calculate the market risk charge for that
offshore site separately. The ADI must calculate the total market risk charge as
the sum of the charge calculated for positions which may be netted according to
conditions (c) to (e) and the charges calculated for each of the offshore sites for
which the conditions (c) to (e) do not allow netting.
APS 116 Attachment B - 13

January 2012
Interest rate risk
3. The standard method for measuring the risk of holding or taking positions in
debt securities and other interest-rate-related instruments in the trading book
covers all fixed-rate and floating-rate debt securities and instruments that
behave like them, including non-convertible preference shares.3 An ADI must
also include interest rate exposures arising from forward foreign exchange
transactions and forward sales and purchases of equities and commodities. An
ADI may include the rho interest rate exposure (exposure to a change in the
value of an option due to a change in the interest rate) on foreign exchange,
equity and commodity options. Convertible bonds must be treated as debt
securities if they trade like debt securities, and as equities if they trade like
equities.
4. In determining the capital charge for interest rate risk, an ADI must separately
calculate the charges applying to the specific risk of each instrument,
irrespective of whether it is a short or a long position, and to the interest rate
risk in the portfolio (general market risk) where long and short positions in
different securities or instruments can be offset.
Specific risk
5. The capital charges for specific risk are outlined in Tables 1 to 5 and paragraphs
6 to 19 of this Attachment. An ADI must not offset between different issues
even if the issuer is the same, but may offset matched long and short positions in
an identical issue (including positions in derivatives).
Table 1: Specific risk capital charges
Category External credit Residual term to maturity Specific

assessment4 risk capital
charge (%)
Government AAA to AA- 0.00
A+ to BBB- 6 months or less 0.25
Greater than 6 months and 1.00
up to and including 24
months
Exceeding 24 months 1.60
BB+ to B- or 8.00
unrated
Below B- 12.00
3
A security which is the subject of a repurchase or securities lending agreement will be treated as
if it were still owned by the lender of the security, i.e. it will be treated in the same manner as
other securitys positions.
4
These external rating grades refer to long-term ratings issued by external credit assessment
institutions within the meaning of APS 112 for the purpose of risk-weighting claims on rated
counterparties and exposures

January 2012
Category External credit Residual term to maturity Specific

assessment4 risk capital
charge (%)
Qualifying 6 months or less 0.25
Greater than 6 months and 1.00
up to and including 24
months
Exceeding 24 months 1.60
Other BB+ to BB- or 8.00
unrated
Below BB- 12.00
6. In Table 1, the government category includes all forms of government paper

including bonds, Treasury notes and other short-term instruments. These debt
instruments may be given a zero specific risk charge if:
(a) they are issued, fully guaranteed or fully collateralised 5 by securities

issued by the Australian Commonwealth, State or Territory governments
or the Reserve Bank of Australia; or
(b) they are issued, fully guaranteed or fully collateralised by securities issued
by central governments or central banks within the Organisation for
Economic Co-operation and Development (OECD); or
(c) they are issued or fully guaranteed by non-OECD country central

governments and central banks and have a residual maturity of one year or
less and are denominated in local currency and the ADIs holdings of such
paper are funded by liabilities in the same currency.
7. The qualifying category includes securities that are:
(a) rated investment grade by at least two external credit assessment

institutions (ECAIs) within the meaning of APS 112 for the purpose of
risk-weighting claims on rated counterparties and exposures; or
(b) rated investment grade by one ECAI or unrated, but deemed, subject to
APRAs written approval, to be of comparable investment quality by the
ADI and the issuer has its equity included in a recognised market index
(refer to Table 8). An ADI must apply to APRA for approval of a policy
statement outlining securities the ADI considers to be of comparable
investment quality.
5
Refer to APS 112 for acceptable collateral and guarantee arrangements.

January 2012
8. In addition, debt securities may be treated as qualifying if they are:
(a) issued or guaranteed by Australian local governments or Australian public

sector entities (except those that have corporate status and operate on a
commercial basis);6
(b) issued or fully guaranteed by non-OECD country central governments or

central banks and have a residual maturity of over one year and are
denominated in local currency and the ADIs holdings of such paper are
funded by liabilities in the same currency;
(c) issued or fully collateralised by claims on an international agency or

regional development bank, including the International Monetary Fund,
the International Bank for Reconstruction and Development, the Bank for
International Settlements and the Asian Development Bank;
(d) issued, guaranteed, endorsed7 or accepted by an Australian ADI or a bank

incorporated in another OECD8 country, provided such instruments do not
qualify as capital of the issuing institution;9
(e) issued, guaranteed, endorsed or accepted by a non-OECD bank and have a

residual maturity of one year or less, provided such instruments do not
qualify as capital of the issuing institution;
(f) issued or guaranteed by OECD state and regional governments or OECD

public sector entities;
(g) issued or guaranteed by an entity that is subject to an equivalent capital

adequacy regime (covering both credit and market risk), as determined by
APRA;10 or
(h) issued by institutions that are deemed in writing by APRA to be

equivalent to investment grade quality and subject to comparable
supervisory and regulatory arrangements.
9. An ADI using the internal ratings-based (IRB) approach for credit risk (refer to
APS 113) for a portfolio may treat debt securities in that portfolio as qualifying
if:
(a) the securities are rated equivalent11 to investment grade under the
reporting ADIs internal rating system, and APRA has confirmed the
rating system complies with the requirements for an IRB approach; and
6
Refer to APS 112.
7
Only where the ADI is the first endorser.
8
This includes banks in non-OECD countries of the Asia-Pacific areas that are accorded the same
credit risk weight as OECD banks under APS 112.
9
Instruments that are regarded as capital of the issuing institution should be assessed on the basis
of the rating of the issue rather than the issuer.
10
Australia Clearing House Pty Ltd, ASX Limited, and the European Economic Communitys
Capital Adequacy Directive are deemed to be equivalent regimes as are the regulators of
investment firms from the following countries: Canada, Hong Kong, Japan, Switzerland and the
USA. An ADI may apply to APRA to have other countries or other regulators added to this list.

January 2012
(b) the issuer has securities listed on a recognised stock exchange within the
meaning of APS 112.
10. Fund-raising instruments issued, guaranteed or accepted by an ADI and

included in the trading book only attract capital charges for general market risk,
not specific risk.12
Specific risk for securitisation exposures13 and resecuritisation exposures
11. An ADI must deduct a securitisation or resecuritisation exposure, unless it

performs the due diligence specified below. This due diligence requires an ADI
to:
(a) on an ongoing basis, have a comprehensive understanding of the risk

characteristics of its individual securitisation exposures, whether on-
balance sheet or off-balance sheet, as well as the pools underlying its
securitisation exposures;
(b) have access to and periodically review performance information on the

underlying pools in a timely manner;
(c) for resecuritisations, have access to and periodically review information

not only on the underlying securitisation tranches but also on the risk
characteristics and performance of the pools underlying the securitisation
tranches; and
(d) have a comprehensive understanding of all structural features of a

securitisation transaction that may have a material impact on the ADIs
exposures to the transaction.
12. An ADI using either the standardised approach for credit risk or the
standardised approach for market risk must calculate specific risk for
securitisation exposures and resecuritisation exposures according to Tables 2
and 3 below. An ADI must deduct from capital (as defined in paragraph 16 of
Attachment B to APS 120) the value of positions with long-term ratings of B+
and below and short-term ratings other than A-1/P-1, A-2/P-2, A-3/P-3. An ADI
must also deduct from capital the value of unrated positions, other than in the
circumstances described in paragraph 6 of Attachment C to APS 120. The
operational requirements for the recognition of external credit assessments
outlined in Attachment B to APS 120 apply.
Table 2: Specific risk capital charges for securitisation exposures and

resecuritisation exposures (long term ratings)
11
Equivalent means the debt security has a one-year probability of default (PD) equal to or less
than the one year PD implied by the long-run average one-year PD of a security with credit
rating grade (refer to APS 112) of three or better.
12
Where the ADI has guaranteed or accepted the instrument, capital must also be held against the
credit risk of the issuer (refer to APS 112).
13
Refer to Prudential Standard APS 120 Securitisation (APS 120) for the definitions of
securitisation exposure and resecuritisation exposure

January 2012
External credit AAA to A+ to BBB+ to BB+ to Below BB- or

assessment AA- A- BBB- BB- unrated
Securitisation 1.6% 4% 8% 28% Deduction from

exposures capital
Resecuritisation 3.2% 8% 18% 52% Deduction from
exposures capital
Table 3: Specific risk capital charges for securitisation exposures and

resecuritisation exposures (short term ratings)
External credit A-1/P-1 A-2/P- A-3/P-3 Below A-3/P-3 or

assessment 2 unrated
Securitisation 1.6% 4% 8% Deduction from
exposures capital
Resecuritisation 3.2% 8% 18% Deduction from
exposures capital
13. An ADI which has approval to use both the internal ratings-based approach for
credit risk and the internal models approach for market risk must calculate the
specific risk capital charges for rated securitisation and resecuritisation
exposures positions according to Tables 4 and 5, depending on whether or not
the positions are granular and/or senior14. The operational requirements for the
recognition of external credit assessments outlined in Attachment B to APS 120
apply.
Table 4: Specific risk capital charges based on external credit assessments (long
term ratings)
External Securitisation exposures Resecuritisation

credit exposures
assessment
Senior, Non-senior, Non- Senior Non-senior
granular granular granular
AAA 0.56% 0.96% 1.60% 1.60% 2.40%
AA 0.64% 1.20% 2.00% 2.00% 3.20%
A+ 0.80% 1.44% 2.80% 2.80% 4.00%
A 0.96% 1.60% 3.20% 5.20%
A- 1.60% 2.80% 4.80% 8.00%
14
Refer to APS 120 for the definitions of senior and granular positions.

January 2012

credit exposures
assessment
Senior, Non-senior, Non- Senior Non-senior
granular granular granular
BBB+ 2.80% 4.00% 8.00% 12.00%
BBB 4.80% 6.00% 12.00% 18.00%
BBB- 8.00% 16.00% 28.00%
BB+ 20.00% 24.00% 40.00%
BB 34.00% 40.00% 52.00%
BB- 52.00% 60.00% 68.00%
Below BB- Deduction from capital
and unrated
Table 5: Specific risk capital charges based on external credit assessments (short
term ratings)

credit exposures
assessment
Senior, Non-senior, Non- Senior Non-
granular granular granular senior
A-1/P-1 0.56% 0.96% 1.60% 1.60% 2.40%
A-2/P-2 0.96% 1.60% 2.80% 3.20% 5.20%
A-3/P-3 4.80% 6.00% 6.00% 12.00% 18.00%
Below A-3/P-3 Deduction from capital
14. An ADI may, if APRA approves, calculate the specific risk capital charges for
unrated securitisation and resecuritisation positions as follows.
(a) An ADI with approval for the IRB approach for the asset classes which
include the underlying exposures may apply the supervisory formula
approach (refer paragraphs 18 to 39 of Attachment D to APS 120). When
estimating PDs and LGDs for calculating KIRB, the ADI must meet the
minimum requirements for the IRB approach.
(b) An ADI which has approval for using a value-at-risk measure for specific
market risk (refer paragraph 43 of Attachment C) for products or asset
classes which include the underlying exposures may apply the supervisory
formula approach (refer paragraphs 18 to 39 of Attachment D to APS
120). When estimating PDs and LGDs for calculating KIRB, the ADI must

January 2012
meet the same standards as for calculating the incremental risk capital
charge according to paragraphs 55 and 56 of Attachment C.
(c) In all other cases an ADI must calculate the capital charge as 8 per cent of
the weighted-average risk weight that would be applied to the securitised
exposures under the standardised approach, multiplied by a concentration
ratio. This concentration ratio is equal to the sum of the nominal amounts
of all the tranches divided by the sum of the nominal amounts of the
tranches junior to or pari passu with the tranche in which the position is
held, including that tranche itself.
The resulting specific risk capital charge must not be lower than any specific
risk capital charge applicable to a rated more senior tranche. If an ADI is unable
to determine the specific risk capital charge as described above or prefers not to
apply the treatment described above to a position, it must deduct that position
from capital.
An ADI must exclude from the calculation of the capital charge for general market
risk a position subject to deduction according to paragraphs 11 to 14 of this
Attachment regardless of whether the ADI applies the standardised measurement
method or the internal models method for the calculation of its general market risk
capital charge.
Specific risk offsetting for the correlation portfolio
15. An ADIs correlation trading portfolio includes securitisation exposures and

nth-to-default credit derivatives that meet all of the following criteria:
(a) the positions are neither resecuritisation positions, nor derivatives of

securitisation exposures that do not provide a pro-rata share in the
proceeds of a securitisation tranche (this criterion therefore excludes
options on a securitisation tranche, or a synthetically leveraged super-
senior tranche);
(b) all reference entities are single-name products, including single-name

credit derivatives, for which a liquid two-way market exists15;
(c) the positions do not reference underlying exposures that would be treated
as a retail exposure, a residential mortgage exposure or a commercial
mortgage exposure under the standardised approach to credit risk (refer to
APS 112); and
(d) the positions do not reference a claim on a special purpose entity.
15
This will include commonly traded indices based on these reference entities. A two-way market
is deemed to exist where there are independent bona fide offers to buy and sell so that a price
reasonably related to the last sales price or current bona fide competitive bid and offer
quotations can be determined within one day and settled at such price within a relatively short
time conforming to trade custom.

January 2012
16. An ADI may also include in the correlation trading portfolio positions that
hedge the positions described above and which are neither securitisation
exposures nor nth-to-default credit derivatives and where a liquid two-way
market (as described in footnote 15) exists for the instrument or its underlying
exposures.
17. APRA may allow an ADI to determine the capital charge for specific interest
rate risk for the correlation trading portfolio as the larger of:
(a) the total specific risk capital charges that would apply just to the net long
positions from the net long correlation trading exposures combined; and
(b) the total specific risk capital charges that would apply just to the net short
positions from the net short correlation trading exposures combined.
Transitional provisions for securitisation positions

18. During a transitional period until 31 December 2013, APRA may allow an ADI
to determine the capital charge for specific interest rate risk for the securitisation
instruments which are not included in the correlation trading portfolio as the
larger of:
(a) the total specific risk capital charges that would apply just to the net long
positions in securitisation instruments in the trading book; and
(b) the total specific risk capital charges that would apply just to the net short
positions in securitisation instruments in the trading book.
This calculation must be undertaken separately from the calculation for the
correlation trading portfolio as described in paragraph 17.
Limitation of specific risk capital charge to maximum possible loss
19. An ADI may limit the capital charge for an individual position in a credit
derivative or securitisation instrument to the maximum possible loss. For a
short risk position an ADI may calculate this limit as a change in value due to
the underlying names immediately becoming default risk-free. For a long
position, the maximum possible loss could be calculated as the change in value
in the event that all the underlying names were to default with zero recoveries.
General market risk
20. The capital charges for general market risk capture the risk of loss arising from
changes in market interest rates. An ADI using the standard method may either
use the maturity method or may apply to APRA for written approval to use the
duration method of measuring general market risk. An ADI that has approval to
use the duration method must do so on a continuing basis, unless a change in
method is approved in writing by APRA. In each method, positions are
allocated across a maturity ladder and the capital charge is calculated as the sum
of four components:
(a) the net short or long weighted position across the whole trading book;

January 2012
(b) a small proportion of the matched positions in each time band (the
vertical disallowance);
(c) a larger proportion of the matched positions across different time bands
(the horizontal disallowance); and
(d) a net charge for positions in options, where appropriate.
21. An ADI must use separate maturity ladders for positions in each currency, with
capital charges calculated separately for each currency and then summed, with
no offsetting between positions of different currencies. Where business in one or
more currencies is insignificant (residual currencies), the ADI may construct a
single maturity ladder for those currencies and record, within each appropriate
time band, the net long or short position in each currency, rather than having to
use separate maturity ladders for each currency. The ADI must sum the absolute
value of the individual net positions within each time band, irrespective of
whether they are long or short positions, to produce a gross position figure.
22. In the maturity method, long or short positions in debt securities and other
sources of interest rate exposures, including derivative instruments, are entered
into a maturity ladder comprising thirteen time bands (or 15 time bands in the
case of low-coupon instruments) (refer to Table 6). An ADI must allocate fixed-
rate instruments according to the residual term to maturity and floating-rate
instruments according to the residual term to the next repricing date. Zero-
coupon bonds and bonds with a coupon of less than three per cent must be
entered according to the time bands set out in the second column of Table 6. An
ADI may omit from the interest rate maturity framework opposite positions of
the same amount in the same issue (but not different issues by the same issuer)
and closely matched swaps, forwards, futures and forward rate agreements
(FRAs) that comply with paragraphs 38 to 40 of this Attachment.
23. To calculate the general market risk capital charge using the maturity method,
an ADI must:
(a) weight the positions in each time band by the risk-weight corresponding to
the positions time band (refer to Table 6); then
(b) offset the weighted longs and shorts within each time band, where
weighted positions arising from low-coupon instruments are combined
with other weighted positions across corresponding time bands; then
(c) offset the weighted longs and shorts within each zone (refer to Table 7),
using only positions that have not been already been offset under (b); then
(d) offset the weighted longs and shorts between zones using positions that
have not already been offset under (b) and (c).
The net amount remaining is the net position.
24. An ADI must then calculate the vertical disallowances for each time band as 10
per cent of the smaller of the offsetting positions determined according to
paragraph 23(b) of this Attachment, whether long or short.

January 2012
25. An ADI must then calculate the horizontal disallowances as the sum of:
(a) 40 per cent of the smaller of the offsetting weighted positions within zone
1 determined according to paragraph 23(c) of this Attachment;
(b) 30 per cent of the smaller of the offsetting weighted positions within
zones 2 and 3 determined according to paragraph 23(d) of this
Attachment; and
(c) 40 per cent of the smaller of the offsetting weighted positions between
zones 1 and 2, and between zones 2 and 3 determined according to
paragraph 23(d) of this Attachment.
26. An ADI must calculate the general market risk capital charge under the maturity
method as the sum of the net position and the vertical and horizontal
disallowances.
27. Under the duration method, an ADI must:
(a) calculate the price sensitivity of each instrument in terms of a change in

interest rates of between 0.6 and 1.0 percentage points depending on the
modified duration of the instrument (refer to Table 6);
(b) enter the resulting sensitivity measures into a duration-based ladder in the
fifteen time bands set out in the second column of Table 6;
(c) subject long and short positions in each time band to a five per cent
vertical disallowance to capture basis risk; and
(d) carry forward the net positions in each time band for horizontal offsetting
subject to the disallowances (refer to Table 7).
28. An ADI must subject the gross positions in each time band for residual
currencies to either the risk weightings in Table 6 if positions are reported using
the maturity method, or the assumed changes in yield in Table 6, if positions are
reported using the duration method, with no further offsets.
Interest rate derivatives

29. An ADIs measurement system must include all interest rate derivatives and off-
balance sheet instruments in the trading book that react to changes in interest
rates. Options must be treated in accordance with the methods outlined in
paragraphs 77 to 95 of this Attachment.
30. An ADI must convert derivatives into positions in the relevant underlying to
become subject to specific and general market risk charges. To determine the
capital charge, the amounts reported must be the market value of the principal
amount of the underlying or of the notional underlying.
31. An ADI must treat futures and forward contracts (including FRAs) as a
combination of a long and a short position in a notional government security or,
in the case of futures or forwards on bank or corporate debt, as a combination of

January 2012
a long and a short position in the underlying debt security. The maturity of a
future or a FRA is the period until delivery or exercise of the contract, plus the
life of the underlying or notional underlying instrument. The long and short
positions must be reported at the market value of the underlying or notional
underlying security or portfolio of securities. Where a range of deliverable
instruments may be delivered to fulfil the contract, the ADI may elect which
deliverable security goes into the maturity or duration ladder but must take
account of any conversion factor defined by the exchange.16
32. An ADI must treat swaps as two notional positions in government securities
with relevant maturities. Both legs of the swap must be reported at their market
values. For swaps that pay or receive a fixed or floating interest rate against
some other reference price, e.g. a stock index, the ADI must enter the interest
rate component into the appropriate repricing maturity category, with the equity
component being included in the equity framework. The separate legs of cross-
currency swaps must be reported in the relevant maturity ladders for the
currencies concerned and the capital for any foreign exchange risk calculated in
accordance with the methods outlined in paragraphs 56 to 64 of this
Attachment.
Pre-processing techniques
33. An ADI may use alternative methods to calculate the positions to be included in
the maturity or duration ladder, subject to APRA determining in writing that it is
satisfied as to the accuracy of the systems being used. Such formulae may be
applied to all interest-rate-sensitive positions, arising from both physical and
derivative instruments, including swaps, FRAs, option delta-equivalents17 and
forward foreign exchange. An ADI may only use an alternative treatment if:
(a) the positions calculated fully reflect the sensitivity of the cash flows to
interest rate changes and are entered into the appropriate time bands; and
(b) the positions allocated to a single maturity ladder are denominated in the
same currency.
34. An ADI may combine positions calculated using a pre-processing method with
any weighted positions calculated using the duration method but must not offset
such positions against weighted positions calculated using the maturity method.
Calculation of capital charge for derivatives under the standard method
35. Interest rate and cross-currency swaps, FRAs, forward foreign exchange
contracts, interest rate futures and futures on an interest rate index are not
subject to a specific risk charge. Where the underlying is a specific debt security
16
In some cases, in permitting delivery of a security against a futures contract the full value of the
contract is not recognised, but rather some pre-specified fraction of the value is recognised; that
fraction is termed the conversion factor.
17
Delta measures the sensitivity of an options value to a change in the price of the underlying
asset.

January 2012
or an index representing a basket of debt securities, a specific risk charge must

be calculated in accordance with paragraphs 5 to 19 of this Attachment.18
36. Bank bill futures contracts traded on the Sydney Futures Exchange are exempt
from a specific risk charge. For other futures or forwards comprising a range of
deliverable instruments with different issuers, a specific risk charge applies to
long positions in the future or forward, but not short positions.
37. Positions in all derivative products are subject to a general market risk capital
charge in the same manner as for cash positions, except for fully or very closely
matched positions in identical instruments in compliance with paragraph 41 of
this Attachment. These positions must be entered into the maturity ladder and
treated according to paragraphs 20 to 28 of this Attachment.
38. An ADI may exclude long and short positions (both actual and notional) in
identical instruments with exactly the same issuer, coupon, currency and
maturity from the interest rate maturity framework. An ADI may also fully
offset, and exclude from the calculation, a matched position in a future or
forward and its corresponding underlying may also be fully offset. The leg
representing the time to expiry of the future (i.e. the net exposure from the
combination of the future and the underlying) must, however, be reported.
39. An ADI may only offset positions in a future or forward comprising a range of
deliverable instruments and the corresponding underlying where there is a
readily identifiable underlying security that is most profitable for the ADI with a
short position to deliver. The price of this security, sometimes called the
cheapest-to-deliver, and the price of the future or forward contract must move
in close alignment.
40. An ADI must not offset between positions in different currencies. It must treat
separate legs of cross-currency swaps or forward foreign exchange deals as
notional positions in the relevant instruments and include them in the
appropriate calculation for each currency.
41. An ADI may fully offset opposite positions within and across product groups,
including (if using the delta-plus method for options)19 the delta-equivalent
value of options (including the delta-equivalent value of legs arising out of the
treatment of caps and floors as set out in paragraph 81 of this Attachment),
subject to meeting the following conditions:
(a) the positions must relate to the same underlying instruments, be of the
same nominal value and be denominated in the same currency;20
18
Forward and futures contracts where the ADI has a right to substitute cash settlement for
physical delivery and the price on settlement is calculated with reference to a general market
price indicator are exempt from specific risk charges, but cannot be offset against specific
securities (including those securities making up the market index).
19
This excludes offsetting between a matched position in a future or forward and its underlying,
which is governed by paragraphs 38 and 39 of this Attachment.
20
The separate legs of different swaps may also be matched subject to the same conditions.

January 2012
(b) for futures, offsetting positions in the notional or underlying instruments

to which the futures contract relates must be for identical products and
mature within seven days of each other;
(c) for swaps, FRAs and forwards,21 the reference rate (for floating-rate
positions) must be identical and the coupons must differ by no more than
15 basis points. Also, the next interest fixing date or, for fixed coupon
positions or forwards, the residual maturity, must correspond within the
following limits:
(i) if either instrument has an interest fixing date or residual maturity

up to and including one month, the dates or residual maturities must
be the same for both instruments; or
(ii) if either of the instrument has an interest fixing date or residual

maturity greater than one month and up to and including one year,
the dates or residual maturities must be within seven days of each
other; or
(iii) if either of the instrument has an interest fixing date or residual

maturity over one year, the dates or residual maturities must be
within thirty days of each other.
Table 6: Time bands and risk weights
Assumed
Risk
Coupon less than 3% or changes
Coupon 3% or more weight
the duration method in yield
(%)
(%)
1 month or less 1 month or less 0.00 1.00
Over 1 and up to 3
Over 1 and up to 3 months 0.20 1.00
months
Over 3 and up to 6
Over 3 and up to 6 months 0.40 1.00
months
Over 6 and up to 12 Over 6 and up to 12
0.70 1.00
months months
Over 1 and up to 2 Over 1.0 and up to 1.9
1.25 0.90
years years
1.75 0.80
years years
2.25 0.75
years years
2.75 0.75
years years
21
Spot or cash positions in the same currency may be offset subject to these same conditions.

January 2012
Assumed
Risk
Coupon less than 3% or changes
Coupon 3% or more weight
the duration method in yield
(%)
(%)
3.25 0.70
years years
3.75 0.65
years years
4.50 0.60
years years
5.25 0.60
years years
Over 10.6 and up to 12
Over 20 years 6.00 0.60
years
Over 12 and up to 20 years 8.00 0.60
Over 20 years 12.50 0.60
Table 7: Horizontal disallowances
Between
Within the Between
Zones22 Time band zones 1 and
zone adjacent zones
3
0 1 month
1 3 months
Zone 1 3 6 months 40%
6 12
months 40% 100%
1 2 years
Zone 2 2 3 years 30%
3 4 years
4 5 years
5 7 years
7 10 years
Zone 3 10 15 years 30%
15 20 years 40% 100%
Over 20
years
22
The zones for coupons less than three per cent are zero to one year, over one to 3.6 years, and
over 3.6 years.

January 2012
Equity position risk
42. The standard method for measuring the risk of equity positions in the trading
book applies to long and short positions in all instruments that exhibit market
behaviour similar to equities. The method covers ordinary shares, whether
voting or non-voting, convertible securities that behave like equities, and
commitments to buy or sell equity securities. An ADI may report long and short
positions in instruments relating to the same issuer on a net basis.
43. An ADI must calculate the long or short position in the market on a market-by-
market basis and must undertake a separate capital calculation for each national
market in which the ADI holds equities.
Specific and general market risks
44. The capital charge for specific risk must be calculated as eight per cent of the
sum of the absolute value of all long equity positions and of all short equity
positions.23
45. The capital charge for general market risk is eight per cent of the net position
(sum of all long equity positions and short equity positions) in an equity market.
Equity derivatives
46. An ADI must include equity derivatives and off-balance sheet positions that are
affected by changes in equity prices in its risk measurement system. Where
equities form one leg of a forward or futures contract (the quantity of equities to
be received or to be delivered), any interest rate or foreign currency exposure
from the other leg of the contract must be reported as set out in paragraphs 3 to
41 and paragraphs 56 to 64 of this Attachment.
47. The treatment of equity options is set out in paragraphs 77 to 95 of this

Attachment. To calculate the relevant charges for equity position risk for other
equity derivatives and other off-balance positions that are affected by changes in
equity prices, an ADI must convert positions into notional equity positions,
where:
(a) futures and forward contracts relating to individual equities are reported at
current market prices;
(b) futures relating to stock indices are reported as the mark-to-market value
of the notional underlying equity portfolio; and
(c) equity swaps are treated as two notional positions.
48. If an ADI takes a position in depository receipts against an opposite position in

the underlying equity or the same equity listed in a different country, it may
only offset the position if any costs on conversion are fully taken into account.
23
An equity position is the net of short and long exposures to an individual company. Hence,
specific risk is assessed on the gross position across companies rather than individual
transactions.

January 2012
49. An ADI may fully offset matched positions in each identical equity or stock
index in each market, resulting in a single net short or long position to which the
specific and general market risk charges will apply. For this purpose, a future in
a given equity may be offset against an opposite physical position in the same
equity.
50. An ADI must apply a specific risk capital charge of two per cent to the net long
or short position in any index contract listed in Table 8.
51. If a position is not listed in Table 8, the ADI must either decompose it into its
component shares or treat it as a single position based on the sum of current
market values of the underlying instruments; if treated as a single position, the
specific risk charge is the highest specific risk charge that would apply to any of
the indexs constituent shares.
52. If an ADI employs a futures-related arbitrage strategy where it:
(a) takes an opposite position in exactly the same index at different dates or in
different market centres; or
(b) has an opposite position in contracts at the same date in different but
similar indices, and subject to APRAs written agreement that the two
indices contain sufficient common components to justify offsetting,
the ADI may apply the additional two per cent capital specific risk capital
charge (referred to in paragraph 50 of this Attachment) to only one index with
the opposite position exempt from a capital charge for both specific risk and
general market risk.
53. Where an ADI engages in a deliberate arbitrage strategy, in which a futures

contract on a broadly-based index matches a basket of shares, the ADI may
decompose the index position into notional positions in each of the constituent
stocks and include these notional positions and the disaggregated physical
basket in the country portfolio, netting the physical positions against the index-
equivalent positions in each stock. The ADI may only apply the capital charge
set out in paragraph 54 of this Attachment if:
(a) the trade has been deliberately entered into and separately controlled; and
(b) the composition of the basket of shares represents at least 90 per cent24 of
the index when broken down into its notional components, or a minimum
correlation between the basket of shares and the index of 0.9 can be
clearly established over a minimum period of one year. An ADI wishing
24
To determine whether a basket of shares represents at least 90 per cent of the index, the relative
weight of each stock in the physical basket is compared to the weight of each stock in the index
to calculate a percentage slippage from the index weights. Stocks that comprise the index but are
not held in the physical basket have a slippage equal to their percentage weight in the index. The
sum of these slippages across each stock in the index represents the total level of slippage from
the index. In summing the percentage differences, no netting is applied between under market-
weight and over market-weight holdings (i.e. the absolute values of the percentage slippages
should be summed). Deducting the total slippage from 100 gives the percentage coverage of the
index to be compared to the required minimum of 90 per cent.

January 2012
to rely on the correlation based criteria will need to satisfy APRA of the
accuracy of the method chosen.
Where these conditions are not met, the ADI must use the approach in
paragraph 55 of this Attachment to deal with the arbitrage.
54. If the values of the physical and futures positions are matched, an ADI must
assess the capital charge as two per cent of the gross value of the positions on
each side, giving a total of four per cent. The ADI must treat any excess value of
the shares comprising the basket over the value of the futures contract, or excess
value of the futures contract over the value of the basket, as an open long or
short position and use the approach in paragraph 55 of this Attachment.
55. Where an arbitrage does not comply with paragraph 53 of this Attachment, the
ADI must treat the index position using the approach in either paragraph 50 or
51 of this Attachment as appropriate. The ADI must then disaggregate the
physical basket of shares into individual positions and include them in the
country portfolio for calculation of the capital charge.
Table 8: Market indices
Country Index Country Index

Nikkei 225, Nikkei 300,
Australia S&P/ASX 200 Japan
TOPIX
Austria ATX Korea Kospi
Belgium BEL20 Netherlands AEX
TSE 35, TSE 100,
Canada Singapore Straits Times Index
TSE 300
Dow Jones Stoxx 50
Index, FTSE
European Spain IBEX 35
Eurotop 300, MSCI
Euro Index
France CAC 40, SBF 250 Sweden OMX
Germany DAX Switzerland SMI
Hong FTSE 100, FTSE mid-250,
Hang Seng 33 UK
Kong FTSE All Share
S&P 500, Dow Jones
Industrial Average,
Italy MIB 30 USA
NASDAQ Composite,
Russell 2000

January 2012
Foreign exchange risk
56. The standard method also covers the risk of holding or taking positions in
foreign currencies and gold.25 Where, however, an ADI is exposed to interest
rate exposure on such positions, the ADI must include the relevant interest rate
positions in the calculation of interest rate risk.
57. The capital charge for foreign exchange risk is eight per cent of the foreign
exchange net open position plus eight per cent of the net position in gold.
Measuring the exposure in a single currency
58. An ADI must include in its net open position in each currency:
(a) the measurement of currency exposure in accordance with paragraphs 14
to 17 of Attachment A; and
(b) the net delta-equivalent of the total book of foreign currency options,
subject to separately calculated capital charges for gamma risk and vega
risk as described in paragraphs 77 to 95 of this Attachment. Alternatively,
options and their associated underlying assets may be subject to one of the
other methods described in paragraphs 77 to 95 of this Attachment.
59. An ADI must separately report positions in composite currencies but, for
measuring its open positions, may treat them as either a currency in their own
right or as split, on a consistent basis, into their component parts.
60. An ADI may treat currency pairs subject to a binding inter-governmental

agreement linking the two currencies as the one currency.
61. An ADI must measure positions in gold in accordance with paragraph 70 of this
Attachment.26 An ADI may double-count gold in Australian dollar equivalent
amounts, first as a gold exposure and secondly as a US dollar exposure,
allowing the US dollar exposure to then be netted against US dollar exposures
arising from other activities.
62. An ADI must value forward currency and gold positions at current spot market
exchange rates. An ADI that bases its normal management accounting on net
present values must use the net present values of each forward position,
discounted using current interest rates and translated at current spot rates, for
measuring its forward currency and gold positions.
Measuring foreign exchange risk in a portfolio of foreign currency positions

and gold
25
Gold must be dealt with as a foreign exchange position rather than as a commodity position
because its volatility is more in line with foreign currencies and it is typically managed in a
similar manner to foreign currencies.
26
Where gold is part of a forward contract (the quantity of gold to be received or to be delivered),
the interest rate and foreign exchange exposure from the other leg of the contract should be
reported as set out in paragraphs 3 to 41 of this Attachment and paragraph 14 of Attachment A.

January 2012
63. Under the standard method, an ADI must convert at spot rates the nominal
amount (or net present value) of the net position in each foreign currency and in
gold into the reporting currency.27 The overall net open position must be
measured by aggregating:
(a) the sum of the net short positions or the sum of the net long positions,
whichever is the greater; plus
(b) the net position (short or long) in gold, regardless of whether positive or
negative.
64. An ADI must calculate the capital charge as eight per cent of the overall net
open position.
Commodities risk
65. The standard method also covers the risk of holding positions in commodities,
including precious metals (excluding gold), where a commodity is defined as a
tradeable physical or energy product, e.g. agricultural products, minerals
(including oil), electricity and precious and base metals.
66. If an ADI is exposed to interest rate or foreign exchange risk from funding
commodities positions, the relevant positions must be included in the
calculation of interest rate and foreign exchange risk.28
67. An ADI using the standard method may measure commodities risk using either
the maturity ladder approach or the simplified approach.
68. Under these approaches, the ADI may report long and short positions in each
commodity on a net basis for the purposes of calculating open positions.
Positions in different commodities must not be offset unless they:
(a) are deliverable against each other; or
(b) are close substitutes for each other and a minimum correlation between
price movements of 0.9 can be clearly established over a minimum period
of one year. An ADI wishing to use correlation-based offsetting must seek
APRAs written approval.
69. Subject to prior written approval from APRA, an ADI may double-count foreign
currency denominated commodities as both a commodity exposure and as a
foreign currency exposure.
27
Where the ADI is assessing its foreign exchange risk on a consolidated basis, it may be
technically impractical in the case of some marginal operations to include the currency positions
of a foreign branch or subsidiary of the ADI. In such cases the internal limit in each currency
applied to such entities may be used as a proxy for the positions. Provided there is adequate ex
post monitoring of actual positions against such limits, the limits are to be added, without regard
to sign, to the net open position in each currency.
28
Where a commodity is part of a forward contract (a quantity of commodities is to be received or
to be delivered), any interest rate, equity or foreign currency exposure from the other leg of the
contract should be reported as set out in paragraphs 3 to 41, 42 to 55 and 56 to 64 of this
Attachment.

January 2012
70. An ADI must first express each commodity position (spot plus forward) in
terms of the standard unit of measurement (barrels, kilos, grams, etc). The net
position in each commodity is then converted at current rates into Australian
dollars.
71. An ADI must include all commodity derivatives and off-balance sheet positions
that are affected by changes in commodity prices in the measurement
framework. These include commodity futures, commodity swaps and options
where the delta-plus method is used.29 In order to calculate the risk, an ADI
must convert commodity derivatives into notional commodities positions and
assign them to maturities such that:
(a) futures and forward contracts relating to individual commodities are

incorporated in the measurement system as notional amounts in terms of
the standard units of measurement multiplied by the spot price of the
commodity, and are assigned a maturity based on the contract's expiry
date;
(b) commodity swaps where one leg is a fixed price and the other leg is the
current market price are incorporated as a series of positions equal to the
notional amount of the contract, with one position corresponding to each
payment on the swap and entered into the maturity ladder accordingly.
The positions are long positions if the ADI is paying fixed and receiving
floating, and short positions if the ADI is receiving fixed and paying
floating;30 and
(c) commodity swaps where the legs are in different commodities are
incorporated in the relevant maturity ladder. An ADI must not offset
positions except as allowed by paragraph 68 of this Attachment.
Maturity ladder approach
72. An ADI using the maturity ladder approach must enter positions in each
separate commodity (expressed in Australian dollar terms) into a maturity band
(refer to Table 9 of this Attachment). Physical stocks must be allocated to the
first time band. Separate maturity ladders must be used for each commodity
except where netting is allowed by paragraph 68 of this Attachment.31
73. Within each time band, an ADI must apply a capital charge for spread risk of
three per cent of the matched position (the smaller of the absolute value of the
short and long positions within a time band).
29
For an ADI using other approaches to measure option price risk, all options and the associated
underlying assets are to be excluded from both the maturity ladder approach and the simplified
approach.
30
If one of the legs involves receiving/paying a fixed or floating interest rate, that exposure is to
be slotted into the appropriate repricing maturity band in the maturity ladder covering interest
rate-related instruments.
31
For markets that have daily delivery dates, any contracts maturing within ten days of one
another may be offset.

January 2012
74. An ADI may then carry forward residual net positions from nearer time bands to
offset exposures in time bands that are further out. A capital charge equal to
0.6 per cent of the net position carried forward is to be applied each time a
position is carried forward to the next time band. The capital charge for each
matched amount created by carrying net positions forward is three per cent of
that matched position.
75. An ADI must apply a capital charge of 15 per cent of the net open position in
the commodity.
Simplified approach
76. An ADI using the simplified approach must apply a capital charge equal to 15
per cent of the overall net position, long or short, in each commodity, plus three
per cent of the ADIs gross positions (the absolute value of all long positions
plus the absolute value of all short positions regardless of maturity) in each
commodity. In valuing the gross positions in commodity derivatives for this
purpose, an ADI must use the current spot price.
Table 9: Commodity time bands
Time band
1 month or less
Over 1 month and up to 3 months
Over 3 months and up to 6 months
Over 6 months and up to 12 months
Over 1 year and up to 2 years
Over 2 years and up to 3 years
Over 3 years
Treatment of options
77. An ADI must obtain prior approval from APRA to use an approach to the
treatment of options. An ADI:
(a) that uses solely purchased options32 may use the simplified approach to
the treatment of options; or
(b) that also writes options must use either the delta-plus method, contingent
loss method or the internal model approach (refer to Attachment C),
depending on the significance of its trading.33
32
Where all the written option positions are hedged by perfetly matched long positions in exactly
the same options, no capital charge for market risk is required.
33
An ADI doing business in certain classes of exotic options (e.g. barriers, digitals) may be
required to use the contingent loss approach (described in paragraphs 89 to 95 of this
Attachment) or the internal models alternative (Attachment C), which can accommodate more
detailed revaluation approaches.

January 2012
78. An ADI must, for the delta-plus method and the contingent loss approach,
calculate the specific risk capital charges separately by multiplying the delta-
equivalent amount of each option by the specific risk weights set out in
paragraphs 3 to 55 of this Attachment.
Simplified approach
79. An ADI using the simplified approach may use the capital charges outlined in
Table 10. In this approach, the positions for the options and the associated
underlying assets, cash or forward, are not subject to the standard methodology
but rather are carved-out and subject to separately calculated capital charges
that incorporate both general market risk and specific risk. The risk numbers
thus generated are then added to the capital charges for the relevant category,
i.e. interest rate related instruments, equities, foreign exchange and
commodities.
Table 10: Simplified approach: Capital charges
Position Treatment
Long cash and The capital charge will be the market value of the
long put underlying security34 multiplied by the sum of specific and
or general market risk charges35 for the underlying less the
amount the option is in the money (if any) bounded at
Short cash and
zero.36
long call
The capital charge will be the lesser of:
Long call (a) the market value of the underlying security
or multiplied by the sum of specific and general market
Long put risk charges for the underlying; and
(b) the market value of the option.37
Delta-plus method
80. An ADI that writes options may be allowed to include delta-weighted options
positions within the standard method. The ADI must report such options as a
position equal to the sum of the market values of the underlying multiplied by
the sum of the absolute values of the deltas. As delta does not cover all risks
34
In some cases, such as foreign exchange, it may be unclear which side is the underlying
security; this should be taken to be the asset which would be received if the option were
exercised. In addition, the nominal value should be used for items where the market value of the
underlying instrument could be zero, e.g. caps and floors, swaptions, etc.
35
Some options (eg where the underlying is an interest rate, a currency or a commodity) bear no
specific risk but specific risk will be present in the case of options on certain interest rate related
instruments and for options on equities and stock indices. The charge under this measure for
currency options will be eight per cent and for options on commodities, 15 per cent.
36
For options with a residual maturity of more than six months, the strike price should be
compared with the forward, not current, price. An ADI unable to do this must take the in-the-
money amount to be zero. For options with a residual maturity of less than six months, an ADI,
if able, is to use the forward price rather than the spot price.
37
Where the position does not fall within the trading book (i.e. options on certain foreign
exchange or commodities positions), it may be acceptable to use the book value instead.

January 2012
associated with options positions, the ADI must measure gamma (which
measures the rate of change of delta) and vega (which measures the sensitivity
of the value of an option with respect to a change in volatility) in order to
calculate the total capital charge. These sensitivities must be calculated using an
approved Exchange model38 or a proprietary options pricing model approved in
writing by APRA.
81. When calculating general market risk using the delta-plus method, an ADI must
place delta-weighted positions with debt securities or interest rates as the
underlying into the interest rate time bands by using a two-legged approach,
where there is one entry at the time the underlying contract takes effect and a
second at the time the underlying contract matures.39 An ADI using the delta-
plus method must treat caps and floors as a series of European-style options.
82. For options with debt securities as the underlying, an ADI must apply a specific
risk charge to the delta-weighted position on the basis of the issuer of the
underlying security according to the approach in paragraphs 5 to 19 of this
Attachment.
83. The capital charge for options with equities as the underlying must also be
based on the delta-weighted positions that will be incorporated in the measure of
market risk (both specific and general market risk) described in paragraphs 42 to
55 of this Attachment. An ADI must calculate the capital charge for options on
foreign exchange and gold positions according to the method in paragraphs 56
to 64 of this Attachment. For delta risk, the net delta-based equivalent of the
foreign currency and gold options must be incorporated into the measurement of
the exposure for the respective currency (or gold) position. The capital charge
for options on commodities must be based on the incorporation of delta-
weighted positions into either the maturity ladder (refer to paragraphs 72 to 75
of this Attachment) or the simplified approach (refer to paragraph 76 of this
Attachment).
84. An ADI using the delta-plus method must calculate the gamma and vega capital
charges for each option position separately.
85. The capital charges for gamma risk must be calculated as:
Gamma impact = gamma (VU)2
where VU denotes the variation in the price of the underlying of the option. VU
must be calculated as follows:
(a) for interest rate options, if the underlying is a bond, the market value of
the underlying must be multiplied by the risk weights outlined in Table 2
of this Attachment. An equivalent calculation, based on the assumed
38
For example, the pricing models used by the Sydney Futures Exchange and the Australian
Securities Exchange Options Market.
39
In the case of options on futures or forwards the relevant underlying is that on which the future
or forward is based (e.g. for a bought call option on a June three-month bill future the relevant
underlying is the three-month bill).

January 2012
changes in yield in Table 2, must be carried out where the underlying is an

interest rate;
(b) for options on equities and equity indices, the market value of the
underlying must be multiplied by eight per cent;
(c) for options on foreign exchange and gold, the market value of the
underlying must be multiplied by eight per cent; and
(d) for options on commodities, the market value of the underlying must be
multiplied by 15 per cent.
86. When calculating the gamma impact, an ADI must treat as the same underlying:
(a) for interest rates,40 each time band outlined in Table 2 for an ADI using
the maturity method. An ADI using the duration method must use the time
bands as set out in the second column of Table 2;
(b) for equities and stock indices, each national market;
(c) for foreign currencies and gold, each currency pair and gold; and
(d) for commodities, each individual commodity as defined in paragraph 68

of this Attachment.
87. Each option on the same underlying will have a gamma impact that is either
positive or negative. An ADI must sum these individual gamma impacts,
resulting in a net gamma impact for each underlying that is either positive or
negative. Only those gamma impacts that are negative are included in the capital
calculation. The total gamma capital charge is the sum of the absolute value of
the net gamma impacts.
88. To calculate vega risk, an ADI must multiply the vega for each option by a
25 per cent proportional shift in the option's current volatility. The results must
then be summed across each underlying. The total capital charge for vega risk is
calculated as the sum of the absolute value of vega across each underlying.
Contingent loss approach

89. An ADI may also base the market risk capital charge for options portfolios and
associated hedging positions on contingent loss matrix analysis. This requires
the ADI to specify a fixed range of changes in the option portfolios risk factors
(i.e. underlying price and volatility) and calculate changes in the value of the
option portfolio at various points along this matrix. For the purpose of
calculating the capital charge, the ADI must revalue the option portfolio using
matrices for simultaneous changes in the options underlying rate or price and in
the volatility of that rate or price. A different matrix must be set up for each
individual underlying as defined in paragraph 86 of this Attachment. As an
alternative, an ADI that is a significant trader in options may, for interest rate
options, base the calculation on a minimum of six sets of time bands if not more
40
Positions must be slotted into separate maturity ladders by currency.

January 2012
than three of the time bands (as defined in column 1 of Table 2) are combined
into any one set.
90. An ADI must evaluate the options and related hedging positions over a specified
range above and below the current value of the underlying to define the first
dimension of the matrix. The range for interest rates is consistent with the
assumed changes in yield in Table 2. An ADI using the contingent loss
approach for interest rate options must use, for each set of time bands, the
highest of the assumed changes in yield applicable to the group to which the
time bands belong.41 The other ranges are eight per cent for equities, eight
per cent for foreign exchange and gold, and 15 per cent for commodities. For
all risk categories, at least seven price shifts (including the current observation)
must be used to divide the range into equally spaced intervals.
91. The second dimension of the matrix entails a change in the volatility of the
underlying rate or price. While a single change in the volatility of the underlying
rate or price equal to a proportional shift in volatility of 25 per cent may be
sufficient in most cases, APRA may require that a different change in volatility
be used and/or that intermediate points on the matrix be calculated.
92. After calculating the matrix, each cell will contain the net profit or loss of the
option and the underlying hedge instrument. The capital charge for each
underlying must then be calculated as the largest loss contained in the matrix.
93. An ADI using the contingent loss approach must calculate the specific risk
charge using the same approach as for the delta-plus method (refer to
paragraphs 82 and 83 of this Attachment).
94. An ADI using the contingent loss approach must comply with the qualitative
standards set out in Attachment B that are appropriate to the nature of the ADIs
business.
95. An ADI undertaking significant options business must, at a minimum, closely

monitor any other risks associated with options, e.g. rho (rate of change of the
value of the option with respect to the interest rate). The ADI may incorporate
rho into its capital calculations for interest rate risk.
41
If, for example, the time-bands three to four years, four to five years and five to seven years are
combined, the highest assumed change in yield of these three bands would be 0.75.

January 2012
Attachment C
The internal model approach
Key requirements
1. The internal model approach is based on the use of value-at-risk (VaR)

techniques. However, an ADI may seek APRAs written approval to use a
capital calculation methodology other than VaR.
2. In addition, an ADI must calculate a stressed VaR measure according to the

requirements set out in paragraph 34 of this Attachment.
3. An ADI using an internal model must meet, on a daily basis, a capital

requirement expressed as:
(a) the higher of:
(i) an average of the daily VaR measures on each of the preceding sixty
trading days, multiplied by a scaling factor (the total of the VaR
multiplication factor and a plus factor); and
(ii) its previous days VaR number; and
(b) the higher of:
(i) an average of the stressed VaR measures calculated over the

preceding sixty trading days, multiplied by a scaling factor (the total
of the multiplication factor for stressed VaR and a plus factor); and
(ii) its latest available stressed VaR number; and
(c) the incremental risk charge (IRC), where the VaR measures referred to in
paragraph 1 of this Attachment include an estimation of the specific risk
charge in accordance with paragraphs 43 to 45 of this Attachment; and
(d) the comprehensive risk charge, where an ADI has approval to calculate
capital for its correlation trading portfolio in accordance with paragraphs
77 to 79 of this Attachment.
Both the VaR multiplication factor and the multiplication factor for stressed
VaR are set by APRA, subject to a minimum of three. If an ADI using an
internal model for calculating its TFC capital requirement does not adequately
satisfy the requirements set out in this Attachment and the trading book
requirements set out in Attachment A, but APRA does not consider the failure
to satisfy those requirements material enough to withdraw model approval,
APRA may, in writing, determine a multiplication factor higher than three. The
plus factor, which ranges between zero and one inclusive, will depend on the ex
post performance of the ADIs internal model, as determined by back-testing of
the VaR measure (refer to paragraphs 81 to 87 of this Attachment).
APS 116 Attachment C - 39

January 2012
4. An ADI that does not have approval from APRA to use an internal model to
calculate its specific risk capital charge must calculate the specific risk capital
charge using the standard method (refer to Attachment B).
5. If an ADIs internal model does not fit the VaR framework, the ADI may seek
approval under paragraph 1 of this Attachment to use an alternative approach. In
deciding whether to approve an alternative approach, APRA will consider
whether the internal model adequately captures the risks involved and identifies
the capital needed to support those risks in a comparable manner.
6. Unless required to do otherwise by APRA:
a. an ADI that has market-related activities in Australia and offshore

activities centrally may, for the purpose of calculating its Level 1 TFC
capital requirement using the internal model approach, allow for
netting of positions that have been taken within the ADI, whether in
Australia or an offshore Level 1 site, and risk diversification between
positions that have been taken by the ADI, whether within Australia or
an offshore Level 1 site (Level 1 globally diversified VaR
calculation); and
b. an ADI that has market-related activities in Australia and offshore

Level 2 sites (offshore branches or offshore subsidiaries) and manages
those market-related activities centrally may, for the purpose of
calculating its Level 2 TFC capital requirement using the internal
model approach, allow for netting of positions that have been taken
within the group comprising the entities in Australia and the offshore
Level 2 sites and risk diversification between positions that have been
taken within the group comprising the entities in Australia and the
offshore Level 2 sites (Level 2 globally diversified VaR calculation);
subject to the following conditions:
c. positions taken in an offshore Level 2 site may only be included in a

globally diversified VaR calculation if the position-taking of that site is
monitored by the ADIs Australian office on a daily basis;
d. positions must not be included in a globally diversified VaR

calculation where there are obstacles to the quick repatriation of profits
from a foreign subsidiary or branch or from offshore transactions taken
by the ADI itself; and
e. positions must not be included in a globally diversified VaR

calculation where there are legal and procedural difficulties in carrying
out the timely management of risks on a consolidated basis.
Where the positions in an offshore Level 2 site are not included in a globally
diversified VaR calculation, an ADI must calculate the VaR for that offshore
Level 2 site separately. The ADI must calculate the total VaR as the sum of the
globally diversified VaR and the VaRs for the offshore Level 2 site.

January 2012
General criteria
7. An ADI using an internal model for regulatory capital purposes must:
(a) have a market risk management system that is conceptually sound and
implemented with integrity;
(b) have sufficient numbers of staff skilled in the use of sophisticated models
in the trading, risk control, audit and back-office areas;
(c) have a proven track record of reasonable accuracy in measuring risk; and
(d) regularly conduct stress tests.
8. An ADI must also be able to participate in testing exercises to provide any

additional information required to satisfy APRA of the adequacy of the internal
model (both prior to model approval and subsequently if APRA wishes to
review the internal model).
Qualitative standards
9. An ADI must have an independent risk control unit that is responsible for the
design and implementation of the ADIs market risk management system. The
risk control unit must produce and analyse daily reports on the output of the
ADIs risk measurement model, including an evaluation of limit utilisation. This
risk control unit must be independent from business trading and other risk-
taking units and must report directly to senior management of the ADI.
10. The risk control unit must conduct a back-testing program at least quarterly that
complies with the minimum requirements in paragraphs 81 to 87 of this
Attachment.
11. The Board, or a Board committee, and senior management of an ADI must be
actively involved in the risk control process and must treat risk control as an
essential aspect of the business, to which significant resources need to be
devoted. The daily reports prepared by the independent risk control unit must be
reviewed by a level of management with sufficient seniority and authority to
enforce both reductions of positions taken by individual traders and reductions
in the ADIs overall risk exposure.
12. An ADIs internal market risk measurement model must be closely integrated
into the day-to-day risk management process of the ADI. Accordingly, the
output of the model must be an integral part of the process of planning,
monitoring and controlling the ADIs market risk profile.
13. An ADIs market risk measurement system must be used in conjunction with
internal trading and exposure limits. An ADIs trading limits must be related to
the ADIs VaR measurement model in a manner that is consistent over time and
that is well understood by both traders and senior management.
14. An ADI must have a routine and robust program of stress testing as a
supplement to the risk analysis based on the day-to-day output of the risk

January 2012
measurement model. The results of stress testing exercises must be used in the
internal assessment of capital adequacy and reflected in the policies and limits
set by management and the Board, or Board committee. The results of stress
testing must be routinely communicated to senior management and,
periodically, to the ADIs Board, or a Board committee.
15. An ADIs risk measurement system must be well documented. An ADI must
have a routine for ensuring compliance with a documented set of internal
policies, controls and procedures concerning the operation of the risk
measurement system.
16. An ADI must ensure that an independent review of the risk measurement system
and overall risk management process is carried out initially (i.e. at the time
when model approval is sought) and then regularly as part of the ADIs internal
audit process. This review must be conducted by functionally independent,
appropriately trained and competent personnel, and must take place at least once
every three years or when a material change is made to the framework. The
review must cover the activities of both the business trading units and the
independent risk control unit and must, at a minimum, specifically address the:
(a) scope of market risks captured by the risk measurement model;
(b) integrity of the management information system;
(c) accuracy and completeness of position data;
(d) verification of the consistency, timeliness and reliability of data sources

used to run internal models, including the independence of such data
sources;
(e) accuracy and appropriateness of volatility and correlation assumptions,

proxy assumptions and (if using the historical simulation approach)
calculations of historical rate movements;
(f) accuracy of valuation and risk sensitivity calculations;
(g) verification of the models accuracy through frequent back-testing;
(h) approval process for risk pricing models and valuation systems used by
front- and back-office personnel;
(i) validation of any significant change in the risk measurement process;
(j) adequacy of the documentation of the risk management system and

process;
(k) organisation of the risk control unit;
(l) integration of market risk measures into daily risk management; and
(m) process used to produce the calculation of market risk capital.

January 2012
Specification of market risk factors
17. An ADI must specify in its risk management system an appropriate set of
market risk factors (market rates and prices that affect the value of the ADIs
market-related positions) that are sufficient to capture the risks inherent in the
ADIs portfolio of on-balance sheet and off-balance sheet trading positions.
18. The VaR model must capture nonlinearities beyond those inherent in options
and other relevant products (e.g. mortgage-backed securities, tranched
exposures or nth loss positions), as well as correlation risk and basis risk (e.g.
between credit default swaps and bonds).
19. Where a risk factor is incorporated in a pricing model but not in the VaR model,
the ADI must justify this omission to APRAs satisfaction. An ADI must also
justify to APRAs satisfaction that all proxies used in the VaR model show a
good track record for the actual position held (i.e. an equity index for a position
in an individual stock).
Interest rates
20. An ADI must specify a set of risk factors corresponding to interest rates in each
currency in which the ADI has interest rate sensitive on-balance sheet or off-
balance sheet trading book positions. The number of risk factors used must be
driven by the nature of the ADIs trading strategies. For material exposures to
interest rate movements in the major currencies and markets, an ADI must
model the yield curves for those currencies using a minimum of six risk
maturity segments.
21. An ADI must specify separate risk factors to capture credit spread risk (e.g.
between government bonds, corporate bonds and swaps).
Equity prices
22. An ADI must specify risk factors corresponding to each of the equity markets to
which it has material positions.
Exchange rates (including gold)

23. An ADI must specify risk factors corresponding to the exchange rate between
the domestic currency and individual foreign currencies in which its positions
are denominated.
Commodity prices
24. An ADI must specify risk factors corresponding to each of the commodity
markets in which it holds material positions.
25. An ADIs commodity risk factors must, at a minimum, encompass:
(a) directional risk, to capture the exposure from changes in spot prices
arising from net open positions;

January 2012
(b) forward gap and interest rate risks, to capture the exposure to changes in
forward prices; and
(c) basis risk, to capture the exposure to changes in the price relationships
between two similar, but not identical, commodities.
26. For more active trading, an ADIs model must also take into account the
variation in the convenience yield42 between derivatives positions, such as
forwards and swaps, and cash positions in the commodity.
Option prices
27. An ADI that may take option positions must specify risk factors corresponding
to the implied volatilities of those options, to capture the vega risk of those
positions.
Quantitative standards
28. An ADI with approval to use an internal model must comply with the
quantitative criteria outlined in paragraphs 29 to 34 of this Attachment for the
purpose of calculating its capital charge. This does not preclude an ADI from
imposing more stringent criteria if it wishes to do so.
29. VaR must be calculated on a daily basis, using a 99 per cent, one-tailed
confidence interval and a 10-day holding period. An ADI which uses VaR
numbers calculated according to a shorter holding period scaled up to ten days
must justify the reasonableness of its approach to APRAs satisfaction
30. The historical observation period (sample period) chosen for calculating VaR
must have a minimum length of one year. An ADI using a weighting scheme or
other method for the historical observation period cannot have a weighted-
average time lag of the individual observations of less than six months43. APRA
may require an ADI to calculate its VaR using a shorter observation period if
APRAs considers this is justified by a significant upsurge in price volatility.
31. An ADI must update its data sets at least monthly and must reassess them
whenever market prices are subject to material changes. An ADI must have
processes in place to update their data sets more frequently.
32. An ADI may only recognise empirical correlations within and across broad risk
categories if approved in writing by APRA
42
The convenience yield reflects the benefits from direct ownership of the physical commodity
(e.g., the ability to profit from temporary market shortages), and is affected both by market
conditions and by factors such as physical storage costs.
43
An ADI may calculate the VaR estimate using a weighting scheme that is not fully consistent
with the requirements of paragraph 30 as long as that method results in a capital charge at least
as conservative as that calculated according to paragraph 30.

January 2012
33. An ADIs model must accurately capture the unique risks associated with
options within each of the broad risk categories, in particular the non-linear
price characteristics of option positions.
34. The stressed VaR measure must be calculated using a 10-day, 99th percentile,
one-tailed confidence interval value-at-risk measure of the current portfolio,
with VaR model inputs calibrated to historical data from a continuous 12 month
period of significant financial stress relevant to the ADIs portfolio. The choice
of historical period is subject to APRA approval, and the ADI must review the
appropriateness of the choice as part of its regular model validation process.
This stressed VaR must be calculated at least weekly.
Stress testing
35. An ADI that uses the internal model approach to meet market risk capital
requirements must have a comprehensive stress testing program.
36. An ADIs stress scenarios must cover a range of factors that can create
extraordinary losses or gains in trading portfolios, or make the control of risk in
those portfolios very difficult. Stress tests must shed light on the impact of such
events on positions that display both linear and non-linear price characteristics
(such as options and instruments that have option-like characteristics).
37. An ADIs stress tests must be both quantitative and qualitative, incorporating
both market risk and liquidity aspects of market disturbances. Quantitative
criteria must identify plausible stress scenarios to which an ADI could be
exposed. Qualitative criteria must emphasise that the two major goals of stress
testing are to evaluate the capacity of the ADIs capital to absorb potential large
losses and to identify steps the ADI can take to reduce its risk and conserve
capital.
38. An ADI must combine the use of supervisory stress scenarios with an internally
developed stress testing program that reflects the risk characteristics of the
ADIs portfolio. The ADI must report to APRA information on stress testing as
required under Reporting Standard ARS 116.0: Market Risk, and as outlined in
paragraph 39 of this Attachment.
39. An ADI must also develop its own stress tests that it identifies as most adverse
based on the characteristics of its portfolio. The ADI must provide APRA with a
description of the methodology used to select and to carry out stress tests and
include this in the description of the ADIs management systems. The stress
tests must also address:
(a) illiquidity/gapping of prices;
(b) concentrated positions (in relation to market turnover);
(c) one-way markets;
(d) non-linear products/deep out-of-the money positions;
(e) events and jumps-to-defaults; and

January 2012
(f) other risks that may not be captured appropriately in VaR (e.g. recovery
rate uncertainty, implied correlations, or skew risk).
The market shocks applied in the tests must reflect the nature of portfolios and
the time it could take to hedge or manage risks under severe market conditions.
40. An ADI must ensure that the results of the stress tests are reviewed periodically
by senior management and reflected in the policies and limits set by
management and the Board, or Board committee.
Model review
41. When reviewing an internal model (both prior to and after model approval),
APRA will consider whether:
(a) the internal validation processes are operating in a satisfactory manner;
(b) the formulae used in the calculation process and for the pricing of options
and other complex instruments are validated by qualified parties, who are
independent from the trading area and not involved in the development or
implementation of those formulae;
(c) the structure of the internal model is adequate with respect to the ADIs
activities and geographical coverage;
(d) the results of the ADIs back-testing of its internal measurement system
ensure the model provides a reliable measure of potential losses over time;
(e) data flows and processes associated with the risk measurement system are
transparent and accessible, in that the models specifications and
parameters can be easily accessed; and
(f) the ADI has processes to ensure that its internal models have been
adequately validated by suitably qualified parties independent of the
development process to ensure that they are conceptually sound and
adequately capture all material risks. This validation must be conducted
when the model is initially developed and when any significant changes
are made to the model.
42. An ADI must validate its internal models on a periodic basis but especially
where there have been any significant structural changes in the market or
changes to the composition of the portfolio that might lead to the model no
longer being adequate. As techniques and best practices evolve, an ADI must
avail itself of these advances. Apart from back-testing, model validation must, at
a minimum, also include:
(a) tests to demonstrate that any assumptions made within the internal model
are appropriate and do not underestimate or overestimate risk;
(b) the use of additional back-tests; and

January 2012
(c) the use of hypothetical portfolios to ensure that the model can account for
particular structural features that may arise.
Treatment of specific risk
43. An ADI that uses an internal model to calculate its regulatory capital in respect
of general market risk may apply to APRA to use an internal model to calculate
its specific risk capital requirement for equities and interest rate risk positions
other than securitisation exposures and nth-to-default credit derivatives. An ADI
using an internal model to calculate its specific risk capital requirement must
comply with the criteria set out in paragraphs 7 to 16, 28 to 34, and 44 to 48 of
this Attachment. An ADI using an internal model to calculate its specific risk
capital requirement for interest rate risk positions other than securitisation
exposures and nth-to-default credit derivatives must also comply with the criteria
set out in paragraphs 49 to 80 of this Attachment.
44. An ADIs internal model used to calculate the specific risk capital requirement
must:
(a) explain the historical price variation in the portfolios concerned;
(b) capture concentrations, resulting in higher capital charges for portfolios

with higher concentrations, and be sensitive to changes in portfolio
composition;
(c) be robust to an adverse environment;
(d) be validated through back-testing designed to assess whether both specific

and general market risks are being accurately captured;
(e) capture name-related basis risk; and
(f) capture event risk44.
45. An ADI's model must conservatively assess the risk arising from less liquid
positions and/or positions with limited price transparency under realistic market
scenarios. An ADI may only use proxies where available data are insufficient or
do not reflect the true volatility of a position or portfolio, and only if the proxies
are appropriately conservative.
Back-testing for specific risk models
46. An ADI using an internal model to measure specific risk must conduct back-
testing to assess whether specific risk is being accurately captured. To validate
its specific risk estimates, the ADI must perform separate back-tests using daily
data on sub-portfolios subject to specific risk, being traded debt and equity
positions. If an ADI decomposes its trading portfolio into finer categories (e.g.
44 ADIs need not capture default and migration risks for positions subject to the incremental risk
capital charge. For equity positions, events that are reflected in large changes or jumps in prices must
be captured, e.g. merger break-ups/takeovers. In particular, ADIs must consider issues related to
survivorship bias.

January 2012
emerging markets and traded corporate debt), the ADI may retain these
distinctions for sub-portfolio back-testing purposes. The ADI, however, is
required to commit to a sub-portfolio structure; hence, changes to the sub-
portfolio structure must be agreed with APRA and be made only where there is
a business case for such a change.
47. An ADI must have a process to analyse exceptions identified through the back-
testing of specific risk to ensure that it can correct its models of specific risk in
the event that they become inaccurate.
48. An ADI with an unacceptable specific risk model (i.e. where the back-testing
results fall within the red zone described in paragraph 86 of this Attachment)
must take immediate action to improve the model and to ensure that there is a
sufficient capital buffer to absorb the risk that the back-test showed had not
been adequately captured.
Incremental risk charge (IRC)

49. An ADI that uses an internal model to calculate regulatory capital for interest
rate specific risk must have an approach to capture the regulatory capital default
and migration risks in positions subject to a capital charge for specific interest
rate risk, with the exception of securitisation positions and nth-to-default credit
derivatives that are incremental to the risk captured by the VaR-based
calculation, as specified in paragraph 1 of this Attachment.
50. An ADI using an internal model to calculate its incremental risk charge must
comply with the criteria set out in paragraphs 51 to 76 and 80 of this
Attachment. An ADI that does not capture the incremental default risk through
an internally developed approach must use the specific risk capital charges
under the standard method (refer to Attachments B and D).
51. The IRC encompasses all positions subject to a capital charge for specific
interest rate risk according to the internal models approach to specific market
risk but not subject to the treatment outlined in paragraphs 11 to 19 of
Attachment B, regardless of their perceived liquidity.
52. With APRA approval, an ADI can choose consistently to include all listed
equity, and derivatives positions based on listed equity, of a desk in its
incremental risk model when such inclusion is consistent with how the ADI
internally measures and manages this risk at the trading desk level. If equity
securities are included in the computation of incremental risk, default is deemed
to occur if the related debt defaults (as defined in paragraphs 75 to 79 of
Attachment A to APS 113).
53. An ADI is not permitted to incorporate into its IRC model any securitisation or
re-securitisation positions, even when these positions are viewed as hedging
underlying credit instruments held in the trading book.

January 2012
54. For IRC-covered positions, the IRC captures:
(a) Default risk. This means the potential for direct loss due to an obligors
default as well as the potential for indirect losses that may arise from a
default event;
(b) Credit migration risk. This means the potential for direct loss due to an
internal/external rating downgrade or upgrade as well as the potential for
indirect losses that may arise from a credit migration event.
IRC soundness standard comparable to IRB
55. For all IRC-covered positions, an ADIs IRC model must measure losses due to
default and migration at the 99.9 per cent confidence interval over a capital
horizon of one year, taking into account the liquidity horizons applicable to
individual trading positions or sets of positions. Losses caused by broader
market-wide events affecting multiple issues/issuers are encompassed by this
definition.
56. For each IRC-covered position an ADIs IRC model must also capture the
impact of rebalancing positions at the end of their liquidity horizons so as to
achieve a constant level of risk over a one-year capital horizon. The model may
incorporate correlation effects among the modelled risk factors, subject to
validation standards set forth in APS 113. The trading portfolios IRC equals the
IRC models estimate of losses at the 99.9 per cent confidence level.
Constant level of risk over one-year capital horizon
57. An ADIs IRC model must be based on the assumption of a constant level of
risk over the one-year capital horizon.
58. This constant level of risk assumption implies that an ADI rebalances, or rolls
over, its trading positions over the one-year capital horizon in a manner that
maintains the initial risk level, as indicated by a metric such as VaR or the
profile of exposure by credit rating and concentration. This means incorporating
the effect of replacing positions whose credit characteristics have improved or
deteriorated over the liquidity horizon with positions that have risk
characteristics equivalent to those that the original position had at the start of the
liquidity horizon. The frequency of the assumed rebalancing must be governed
by the liquidity horizon for a given position.
59. Rebalancing positions does not imply, as the IRB approach for the banking
book does, that the same positions will be maintained throughout the capital
horizon. However, an ADI may elect to use a one-year constant position
assumption, as long as it does so consistently across all portfolios.
Liquidity horizon
60. The liquidity horizon represents the time required to sell the position or to hedge
all material risks covered by the IRC model in a stressed market. The liquidity
horizon must be measured under conservative assumptions and should be

January 2012
sufficiently long that the act of selling or hedging, in itself, does not materially
affect market prices. The determination of the appropriate liquidity horizon for a
position or set of positions may take into account an ADIs internal policies
relating to, for example, prudent valuation (as per the prudent valuation
guidance of Attachment E to APS 111), valuation adjustments45 and the
management of stale positions.
61. The liquidity horizon for a position or set of positions has a floor of three
months.
62. An ADI must use conservative assumptions regarding the liquidity horizon for
non-investment-grade positions until further evidence is gained regarding the
markets liquidity during systematic and idiosyncratic stress situations. An ADI
must also apply conservative liquidity horizon assumptions for products,
regardless of rating, where either (i) secondary market liquidity is not deep,
particularly during periods of financial market volatility and investor risk
aversion; or (ii) the product is from a rapidly growing class that has not been
tested in a downturn.
63. An ADI can assess liquidity by position or on an aggregated basis (buckets).

If an aggregated basis is used46, the aggregation criteria would be defined in a
way that meaningfully reflects differences in liquidity.
64. The liquidity horizon must be greater for positions that are concentrated,
reflecting the longer period needed to liquidate such positions.
65. The liquidity horizon for a securitisation warehouse must be longer than three
months, and reflect the time to build, sell and securitise the assets, or to hedge
the material risk factors, under stressed market conditions.
Correlations and diversification
(a) Correlations between defaults and migrations
66. An ADIs IRC model must include the impact of clustering of default and
migration events that may arise as a result of correlations between default and
migration events among obligors.
(b) Correlations between default or migration risks and other market factors
67. An ADI may not include the impact of diversification between default or
migration events and other market variables in the computation of capital for
incremental risk. Accordingly, the capital charge for incremental default and
migration losses is added to the VaR-based capital charge for market risk.
Concentration
68. An ADIs IRC model must appropriately reflect issuer and market
concentrations. Thus, other things being equal, a concentrated portfolio should
45
For establishing prudent valuation adjustments, see also Attachment E to APS 111.
46
For example, investment-grade European corporate exposures not part of a core CDS index

January 2012
attract a higher capital charge than a more granular portfolio (see also paragraph
64). Concentrations that can arise within and across product classes under
stressed conditions must also be reflected.
Risk mitigation and diversification effects
69. Within an ADIs IRC model, exposure amounts may be netted only when long
and short positions refer to the same financial instrument. Otherwise, exposure
amounts must be captured on a gross (i.e. non-netted) basis. Thus, hedging or
diversification effects associated with long and short positions involving
different instruments or different securities of the same obligor (intra-obligor
hedges), as well as long and short positions in different issuers (inter-obligor
hedges), may not be recognised through netting of exposure amounts. Rather,
such effects may only be recognised by capturing and modelling separately the
gross long and short positions in the different instruments or securities.
70. An ADIs IRC model must include the impact of significant basis risks by
product, seniority in the capital structure, internal or external rating, maturity,
vintage for offsetting positions as well as differences between offsetting
instruments, such as different payout triggers and procedures.
71. If an instrument has a maturity shorter than the liquidity horizon or if a maturity
longer than the liquidity horizon is not contractually assured, an ADIs IRC
model must, where material, include the impact of potential risks that could
occur during the interval between the maturity of the instrument and the
liquidity horizon.
72. For trading book risk positions that are typically hedged via dynamic hedging
strategies, a rebalancing of the hedge within the liquidity horizon of the hedged
position may also be recognised. Such recognition is only admissible if the ADI
(i) chooses to model rebalancing of the hedge consistently over the relevant set
of trading book risk positions, (ii) demonstrates that the inclusion of rebalancing
results in a better risk measurement, and (iii) demonstrates that the markets for
the instruments serving as hedge are liquid enough to allow for this kind of
rebalancing even during periods of stress. Any residual risks resulting from
dynamic hedging strategies must be reflected in the capital charge. An ADI
must validate its approach to capture such residual risks to APRAs satisfaction.
Optionality
73. An ADIs IRC model must include the nonlinear impact of options and other
positions with material nonlinear behaviour with respect to price changes. The
ADI must also have due regard to the amount of model risk inherent in the
valuation and estimation of price risks associated with such products.
Validation
74. In designing, testing and maintaining their IRC models an ADI must evaluate
conceptual soundness and conduct ongoing monitoring, including process
verification and benchmarking, and outcomes analysis. Some factors that must
be considered in the validation process include:

January 2012
(a) Liquidity horizons must reflect actual practice and experience during
periods of both systematic and idiosyncratic stresses;
(b) The IRC model for measuring default and migration risks over the
liquidity horizon must take into account objective data over the relevant
horizon and include comparison of risk estimates for a rebalanced
portfolio with that of a portfolio with fixed positions;
(c) Correlation assumptions must be supported by analysis of objective data

in a conceptually sound framework. If an ADI uses a multi-period model
to compute incremental risk, it must evaluate the implied annual
correlations to ensure they are reasonable and in line with observed annual
correlations. An ADI must validate that its modelling approach for
correlations is appropriate for its portfolio, including the choice and
weights of its systematic risk factors. An ADI must document its
modelling approach so that its correlation and other modelling
assumptions are transparent to supervisors; and
(d) Owing to the high confidence standard and long capital horizon of the
IRC, robust direct validation of the IRC model through standard back-
testing methods at the 99.9 per cent/one-year soundness standard will not
be possible. Accordingly, validation of an IRC model necessarily must
rely more heavily on indirect methods including but not limited to stress
tests, sensitivity analyses and scenario analyses, to assess its qualitative
and quantitative reasonableness, particularly with regard to the models
treatment of concentrations. Such tests must not be limited to the range of
events experienced historically. An ADI must agree its set of validation
procedures with APRA.
Use of internal risk measurement models to compute the IRC
75. The approach that an ADI uses to measure the IRC is subject to the use test.
Specifically, the approach must be consistent with the ADIs internal risk
management methodologies for identifying, measuring, and managing trading
risks.
76. Where an ADIs internal approach for measuring the IRC does not satisfy all
requirements of paragraphs 49 to 75, the ADI must demonstrate that the
resulting internal capital charge would deliver a charge at least as high as the
charge produced by a model that directly applies the supervisory principles set
out in this Attachment.
Comprehensive risk measure
77. An ADI that is active in buying and selling products that meet the criteria for
inclusion in the correlation trading portfolio (refer to paragraph 15 of
Attachment B) may apply to APRA to use an internal model to calculate its
specific risk capital requirement for its correlation trading portfolio in an
internally developed approach that adequately captures not only incremental
default and migration risks, but all price risks (the comprehensive risk

January 2012
approach). The value of such products is subject in particular to the following

risks which must be adequately captured:
(a) the cumulative risk arising from multiple defaults, including the ordering
of defaults, in tranched products;
(b) credit spread risk, including the gamma and cross-gamma effects;
(c) volatility of implied correlations, including the cross effect between

spreads and correlations;
(d) basis risk, including both:
(i) the basis between the spread of an index and those of its constituent
single names; and
(ii) the basis between the implied correlation of an index and that of
bespoke portfolios;
(e) recovery rate volatility, as it relates to the propensity for recovery rates to
affect tranche prices; and
(f) to the extent the comprehensive risk measure incorporates benefits from
dynamic hedging, the risk of hedge slippage and the potential costs of
rebalancing such hedges.
The approach must meet all of the requirements specified in paragraphs 55, 56,
78 and 79. Exposures for which the ADI does not meet the due diligence
requirements set out in paragraph 11 of Attachment B must be deducted in
accordance with that paragraph, and may not be included in the comprehensive
risk approach. For the exposures that the ADI does incorporate in its
comprehensive risk approach, the ADI will be required to subject them to a
capital charge equal to the higher of the capital charge according to this
internally developed approach and 8 per cent of the capital charge for specific
risk according to the standardised measurement. It will not be required to
calculate an incremental risk charge for these positions.. It must, however,
incorporate them in both the VaR and stressed VaR measures.
78. For an ADI to apply the comprehensive risk approach for calculating capital, it
must:
(a) have sufficient market data to ensure that it fully captures the salient risks
of these exposures in its comprehensive risk measure in accordance with
the standards set forth above;
(b) demonstrate (e.g. through back-testing) that its risk measures can
appropriately explain the historical price variation of these products; and
(c) ensure that it can separate the positions for which it holds approval to
incorporate them in its comprehensive risk measure from those positions
for which it does not hold this approval.

January 2012
79. An ADI applying the comprehensive risk approach must report to APRA
information on comprehensive risk stress testing, including comparisons with
the capital charges implied by the ADIs internal model for estimating
comprehensive risks, as required under Reporting Standard ARS 116.0: Market
Risk. The ADI must also apply these stress scenarios at least weekly, and any
instances where the stress tests indicate a material shortfall of the
comprehensive risk measure must be reported to APRA in a timely manner.
Based on these stress testing results, or if an ADI does not adequately meet the
requirements of paragraphs 77 and 78, APRA may impose a supplemental
capital charge against the correlation trading portfolio, to be added to the ADIs
internally modelled capital requirement.
Frequency of calculation
80. An ADI that uses an internal model to calculate regulatory capital for the
incremental risk measure and/or the comprehensive risk approach must
calculate the measure(s) at least weekly, or more frequently as directed by
APRA. The capital charge for incremental risk is given by the maximum of:
(a) the average of the incremental risk measures over 12 weeks; and
(b) the most recent incremental risk measure.
The capital charge for comprehensive risk is given by the maximum of:
(a) the average of the comprehensive risk measures over 12 weeks; and
(b) the most recent comprehensive risk measure.
Framework for the use of back-testing
81. An ADIs back-testing program must consist of a periodic comparison of its

daily VaR measure (based on a one-day holding period) with the realised daily
profit or loss (trading outcome). The program must include a formal
evaluation of instances where trading outcomes are not covered by the risk
measures (termed exceptions) on at least a quarterly basis, using the most
recent twelve months of VaR and profit data. The ADI must document all of the
exceptions generated from its ongoing back-testing program, including an
explanation for the exceptions. An ADI must have the capacity to perform back-
testing analysis both at the level of the whole portfolio and at the level of sub-
portfolios or books or that contain material risk.
82. An ADI must perform back-tests using both actual trading outcomes and
hypothetical trading outcomes. Hypothetical trading outcomes are calculated by
applying the days price movements to the previous days end-of-day portfolio.
When performing back-tests using actual trading outcomes, an ADI must use
clean trading outcomes, i.e. actual trading outcomes adjusted to remove the
impact of income arising from factors other than market movements alone, such
as fees and commissions, brokerage, additions to and releases from reserves
which are not directly related to market risk (e.g. administration reserves).

January 2012
83. An ADI must calculate the number of exceptions for use by APRA in
developing its supervisory response. For this purpose, the ADI must use either
the hypothetical trading outcomes or clean trading outcomes as determined in
writing by APRA. The plus factor to be added to the multiplication factor will
be based on the number of exceptions out of the most recent 250 trading days.
These plus factors are outlined in Table 11.
Table 11: Plus factors
Zone Number of exceptions Plus factor

Green Zone 4 or less 0.00
5 0.40
6 0.50
Yellow Zone 7 0.65
8 0.75
9 0.85
Red Zone 10 or more 1.00
84. If the results of an ADIs back-testing fall within zero to four exceptions (the
green zone), the ADI is not required to add a plus factor to the multiplication
factor.
85. If the results of the ADIs back-testing fall within 5 to 9 exceptions (the yellow
zone), APRA may, in writing, require the ADI to add a plus factor in
accordance with Table 11.
86. If an ADIs back-testing results in 10 or more exceptions (the red zone), the
ADI must submit to APRA analysis which identifies the causes for each of the
exceptions, and must also add a plus factor of 1 to the multiplication factor
unless otherwise directed by APRA.
87. APRA, in writing, may also require the ADI to take appropriate action in
addition to the plus factor, depending on the nature of the exceptions. Where the
exceptions arise from:
(a) issues with the basic integrity of the model, APRA may require the ADI to
make appropriate corrections to the model or, if there are severe problems
relating to the basic integrity of the model, APRA may revoke the ADIs
model approval under paragraph 18 of this Prudential Standard;
(b) the need for improvement in the accuracy of the model, APRA may
require the ADI to improve its risk measurement techniques; and
(c) unanticipated market movements, APRA may require the ADI to

recalculate its VaR using volatilities and correlations based on a shorter
historical observation period if the shifts in volatilities and/or correlations
are deemed to be permanent.

January 2012
Attachment D
Treatment of credit derivatives in the trading book
1. An ADI must determine the capital to be held against credit derivative

instruments in the trading book in accordance with this Attachment.
2. An ADI must include in its trading book total-rate-of-return swaps, except those
that have been transacted to hedge a banking book credit exposure in
accordance with the requirements in Attachment H to APS 112. An ADI must
include open short positions in credit derivatives in its trading book. APRA may
in writing exempt the ADI from this requirement on a one-off approval basis.
When determining whether other credit derivative transactions should be
allocated to the banking or trading book, the ADI must consider the trading
book requirements outlined in Attachment A to this Prudential Standard. Before
including other credit derivative transactions (i.e. transactions other than total-
rate-of-return swaps and open short positions) in its trading book, the ADI must
undertake a written assessment setting out its reasons for doing so. The ADI
must provide its written assessment to APRA upon request. APRA may make a
determination requiring the ADI to allocate the transaction to the banking book
where APRA considers that this is more appropriate given the nature of the
transaction.
Application
3. This Attachment applies to single name credit-default swaps, certain total-rate-

of-return swaps, cash-funded credit-linked notes and first- and second-to-default
baskets. An ADI that transacts more complex credit derivatives that fall outside
the scope of this Attachment must, prior to execution of the relevant credit
derivative contract, undertake a written assessment of the appropriate regulatory
capital treatment for the transaction. The ADI must provide its written
assessment to APRA upon request. The ADI must apply the treatment set out in
its written assessment unless APRA determines in writing an alternative
methodology for calculating the regulatory capital treatment.
4. Where APRA considers that an ADI is undertaking significant credit derivative

activity, as either a purchaser or seller of protection, such that large exposures
and concentrations are a potential concern, APRA may, in writing, require the
ADI to adopt an alternative capital treatment to that described in this
Attachment.
5. An ADI may use either the standard method or, with APRAs approval, either
an internal model or other method to measure the general market risk and
specific risk charges on credit derivative positions in the trading book. This
Attachment outlines only the calculation of the capital charge for credit
derivatives under the standard method. An ADI that wishes to use an internal
risk measurement model to generate the capital requirement must obtain
APRAs written approval.
APS 116 Attachment D - 56

January 2012
General principles - General market risk
6. An ADI that uses the standard method must treat credit derivatives based on a
single reference entity in the same way as interest-rate-related derivatives (refer
to Attachment B) for the purposes of calculating a general market risk capital
charge. Each credit derivative instrument must be broken down into a notional
debt instrument, to reflect the interest rate or fee-paying leg (if regular fees are
paid under the terms of the contract) and, where applicable, a position in the
reference obligation.
7. An ADI must include these positions in the maturity ladder applicable to the
currency of the cash flows and report at their market values.
General principles - Specific risk
8. Where the credit-event payment is defined as the par value of the reference
obligation less its recovery value (i.e. the credit derivative is cash settled), an
ADI must report for specific risk purposes the par value of the reference
obligation. Where the credit-event payment is defined as a fixed amount, the
ADI must report the fixed amount. Where there is payment of the par value of
an obligation in exchange for its physical delivery, the ADI must report the par
value of the obligation. In the latter two cases, the amount reported must reflect
a position in the reference entity with maturity equal to the term to maturity of
the credit derivative.
Credit-default swaps
9. If an ADI is a protection buyer in a credit-default swap, it must enter into the

maturity ladder a short position in a notional debt instrument, where regular
interest or fee cash flows are to be paid, to reflect the general market risk
associated with those cash flows. The ADI must also calculate a specific risk
capital charge on a short position in the reference entity.
10. If an ADI is a protection seller in a credit-default swap, it must enter into the
maturity ladder a long position in a notional debt instrument, where regular
interest or fee cash flows are to be received, to reflect the general market risk
associated with those cash flows. The ADI must also calculate a specific risk
capital charge on the long position in the reference entity.
Total-rate-of-return swaps
11. If an ADI is a protection buyer in a total-rate-of-return swap, it must enter into

the maturity ladder a position in a notional debt instrument, where regular
interest or fee cash flows are to be exchanged, to reflect the general market risk
associated with those cash flows. General market risk and specific risk capital
charges must also be calculated on the short position in the reference obligation.
12. If an ADI is a protection seller in a total-rate-of-return swap, it must enter into

the maturity ladder a position in a notional debt instrument, where regular
interest or fee cash flows are to be exchanged, to reflect the general market risk

January 2012
associated with those cash flows. General market risk and specific risk capital
charges must also be calculated on the long position in the reference obligation.
Cash-funded credit-linked notes
13. If an ADI is a protection buyer in a credit-linked note, it must enter into the
maturity ladder a short position in the underlying interest rate instrument for
general market risk purposes. The ADI must also calculate a specific risk capital
charge on the short position in the reference entity.
14. If an ADI is a protection seller in a credit-linked note, it must enter into the
maturity ladder a long position in the underlying interest rate instrument for
general market risk purposes. The ADI must calculate a specific risk capital
charge on the long position in the reference entity and the long position in the
underlying interest rate instrument (i.e. the long position in the protection
buyer).
Nth-to-default basket credit derivatives
15. If an ADI is a protection buyer in a first- or second-to-default basket, it must

enter into the maturity ladder a short position in a notional debt instrument,
where regular interest or fee cash flows are to be paid, to reflect the general
market risk associated with those cash flows.
16. If an ADI is a protection seller in a first- or second-to-default basket, it must

enter into the maturity ladder a long position in a notional debt instrument,
where regular interest or fee cash flows are to be received, to reflect the general
market risk associated with those cash flows.
17. An ADI must determine the capital charge for specific risk for an n th-to-default
credit derivative as follows:
(a) The capital charge for specific risk for a first-to-default credit derivative is
the lesser of (1) the sum of the specific risk capital charges for the
individual reference credit instruments in the basket, and (2) the maximum
possible credit event payment under the contract. Where an ADI has a risk
position in one of the reference credit instruments underlying a first-to-
default credit derivative and this credit derivative hedges the ADIs risk
position, the ADI is allowed to reduce with respect to the hedged amount
both the capital charge for specific risk for the reference credit instrument
and that part of the capital charge for specific risk for the credit derivative
that relates to this particular reference credit instrument. Where an ADI
has multiple risk positions in reference credit instruments underlying a
first-to-default credit derivative this offset is allowed only for that
underlying reference credit instrument having the lowest specific risk
capital charge.
(b) The capital charge for specific risk for an nth-to-default credit
derivative with n greater than one is the lesser of (1) the sum of the
specific risk capital charges for the individual reference credit instruments
in the basket but disregarding the (n-1) obligations with the lowest specific

January 2012
risk capital charges; and (2) the maximum possible credit event payment
under the contract. For nth-to-default credit derivatives with n greater than
1 no offset of the capital charge for specific risk with any underlying
reference credit instrument is allowed.
(c) If an ADI is a protection seller, then where a first- or second-to-default

basket product has an external credit assessment47 from an ECAI, the ADI
must calculate the specific risk capital charge using the rating of the
derivative and apply the respective securitisation risk weights as specified
in paragraphs 12 or 13 of Attachment B, as applicable.
(d) The capital charge against each net nth-to-default credit derivative
position applies irrespective of whether the ADI has a long or short
position, i.e. obtains or provides protection.
Specific risk offsetting
18. An ADI may recognise full allowance for offsetting when the values of two legs
(i.e. long and short) always move in the opposite direction and broadly to the
same extent. This occurs where:
(a) the two legs consist of completely identical instruments; or
(b) a long cash position is hedged by a total rate of return swap (or vice versa)
and there is an exact match between the reference obligation and the
underlying exposure (i.e. the cash position).48 In these cases, specific risk
capital requirements do not apply to either side of the position.
19. An ADI may recognise an offset of 80 per cent when the value of two legs (i.e.
long and short) always moves in the opposite direction but not broadly to the
same extent. This would be the case when a long cash position is hedged by a
credit-default swap or a credit-linked note (or vice versa) and there is an exact
match in terms of the reference obligation, the maturity of both the reference
obligation and the credit derivative, and the currency of the underlying
exposure. In addition, key features of the credit derivative contract (e.g. credit-
event definitions, settlement mechanisms) must not cause the price movement
of the credit derivative to materially deviate from the price movements of the
cash position. To the extent that the transaction transfers risk (i.e. taking account
of restrictive payout provisions such as fixed payouts and materiality
thresholds), an 80 per cent specific risk offset may be applied to the side of the
transaction with the higher capital charge, while the specific risk requirement on
the other side is zero.
20. An ADI may recognise a partial offset when the value of the two legs (i.e. long
and short) usually moves in the opposite direction. This occurs where:
(a) the position is captured in paragraph 18(b) of this Attachment but there is
an asset mismatch49 between the reference obligation and the underlying
47 Refer to APS 112.

48
The maturity of the swap itself may be different from that of the underlying exposure.
49
Refer to Attachment H of APS 112 for the definition of asset mismatch.

January 2012
exposure; nonetheless, the position meets the requirements for an asset

mismatch to be allowed for credit risk mitigation purposes as set out in
Attachment H to APS 112; or
(b) the position is captured in paragraphs 18(a) or 19 of this Attachment but

there is a currency or maturity mismatch50 between the credit protection
and the underlying asset; or
(c) the position is captured in paragraph 19 of this Attachment but there is an

asset mismatch between the cash position and the credit derivative.
However, the underlying asset is included in the (deliverable) obligations
in the credit derivative documentation.
In each of these situations, rather than adding the specific risk capital
requirements for each side of the transaction, an ADI may apply only the higher
of the two capital requirements.
21. If an instrument does not comply with paragraphs 18, 19 or 20 of this

Attachment, the ADI must assess a specific risk capital charge against both
sides of the position.
50
Refer to Attachment H of APS 112 for the definitions of currency mismatch and maturity
mismatch. Currency mismatches are to feed into the normal reporting of foreign exchange risk.

Aps 116 Market Risk Final Jan2012

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Aps 116 Market Risk Final Jan2012

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January 2012

Prudential Standard APS 116

This Prudential Standard aims to ensure that an authorised deposit-taking institution

have a framework to manage, measure and monitor market risk commensurate

use the standard method or an APRA-approved internal model approach to

2. This Prudential Standard applies to all authorised deposit-taking institutions

(b) ADIs that:

(ii) have included a statement to this effect in their description of their

3. A reference to an ADI in this Prudential Standard shall be taken as a reference

(a) an ADI on a Level 1 basis; and

(b) a group of which an ADI is a member on a Level 2 basis.

Where an ADI to which this Prudential Standard applies is a subsidiary of an

4. This Prudential Standard applies to all:

(a) trading book positions; and

For the purposes of this Prudential Standard, no distinction is drawn, in

5. The treatment of counterparty credit risk capital requirements is excluded from

6. The following definitions are used in this Prudential Standard:

(a) credit-event payment - the amount that is payable by the credit

(f) marking-to-model - any valuation that has to be benchmarked,

(h) nth-to-default credit derivative - a contract where the payoff is based on

A reference obligation is relevant for obligations that are to be cash settled

(l) traded market risk, foreign exchange and commodities capital

7. An ADI that wishes to operate a trading book must, in accordance with

8. An ADI must allocate positions in financial instruments to its trading book if

11. An ADI must hold capital against:

(b) all foreign exchange and commodity risks.

The TFC capital requirement

13. Unless required to do otherwise by APRA (and subject to the conditions in

(a) an ADI that has market-related activities in Australia and offshore

The standard method

The internal model approach

components of the market risk management framework. APRA may impose

(b) it is appropriate, having regard to the particular circumstances of the ADI,

Combination of the internal model approach and the standard method

Governance and the trading book policy statement

Board and senior management responsibilities

1. An ADIs Board of directors (Board) is responsible for approving strategies and

The trading book

3. An ADI must allocate to the trading book positions in financial instruments,

(a) are held for short-term resale; or

(c) arise from broking and market-making.

4. For a position to be eligible to receive trading book capital treatment, an ADI

(a) a clearly documented trading strategy for the position/instrument or

(i) positions are managed on a trading desk;

(ii) position limits are set and monitored for appropriateness;

APS 116 Attachment A - 8

(iv) positions are marked-to-market daily and when marking-to-model

(v) positions are reported to senior management as an integral part of

(vi) positions are actively monitored with reference to market

8. An ADI may only include term trading-related repo-style transactions that it

9. For transactions dealt internally within an ADI, the ADI:

(a) must either:

(i) eliminate all internal transactions between portfolios within the

(ii) include any or all internal deals in their position measurement

APS 116 Attachment A - 9

The trading book policy statement

11. An ADIs trading book policy statement must detail:

(d) the valuation methodology to be adopted for trading book exposures,

(i) the extent to which an exposure can be marked-to-market daily by

(A) identify the material risks of the exposure;

(C) derive reliable estimates for the key assumptions and

APS 116 Attachment A - 10

(g) the extent to which legal restrictions or other operational requirements

Measuring currency exposure